I've Got Friends In Low Places
I've Got Friends In Low Places...We have to admit that Fed actions announced at the last FOMC meeting very much took us by surprise. Point being, we did not expect the Fed to begin monetization so soon. But surprised we should not have been. Not by a long shot. To be honest, Fed monetization of Treasury debt was inevitable in the current cycle. The recent global capital flow and realized/expected Treasury issuance numbers over the last half-year really tell the whole story quite elegantly. So although there has been plenty of ranting and raving about Fed monetization, ourselves included, we think it's much more important to our forward investment decision making to simply address this fact objectively and unemotionally. The Fed really had no other choice. Moreover, as we'll discuss, this is the beginning of monetization actions by the Fed. They're just getting warmed up. THE issue now is not the monetization itself, but rather how monetization will influence investment risk and opportunities. We'll divide up in sections the highlight points we believe tell the story of the need for the Fed to monetize and why they will not be able to stop any time soon.
THE TREASURY CALENDAR
To the point, the top clip of the chart below chronicles the issuance of US Treasuries since the beginning of 2006. Alongside is the quarterly level of like period purchases of US Treasuries by the foreign community. As we note in the chart, 3Q and 4Q of last year mark the highest nominal dollar levels of Treasury purchases by the foreign community on record. But these purchase levels were simply dwarfed by the $1 trillion+ issuance of Treasuries over the last half of 2008.
The bottom clip of the chart takes the same data and presents it as foreign purchases of UST's as a percentage of actual Treasuries issued by quarter since 2006. The "rule" in this view of life is that the foreign community has consistently purchased well in excess of 50% of total Treasuries issued. In fact, from 3Q of 2007 through 2Q of 2008, the foreign community purchased Treasuries at a rate well in excess of 100% of total Treasuries issued. But as is absolutely clear, all of this has changed starting in the middle of last year. The bottom line today is that foreign buying of Treasuries, although at record levels in nominal dollars, has not been able to keep up with what has been and will continue to be for some time Treasury issuance on steroids. Although we will not drag you through yet another data review, you'll have to trust us when we tell you that domestic buying of Treasuries has not and will not make up the gap. As of today, total domestic ownership of Treasuries rests at a level below that of the foreign community. The Fed is now quite simply the plug figure between projected Treasury issuance, foreign buying and levels of domestic Treasury ownership. The fact is that the Fed had no choice but to come into play right now. And so here we are. No conspiracies, no mysteries, no ranting and raving, simply the factual numbers.
Very quickly, as of right now, the OMB (Office of Management and Budget) has projected at worst an annualized $1.8 trillion deficit for the US later in the current year. From this alone we know Treasury issuance will be incredibly large. Well beyond what the foreign community would ever have the chance of soaking up. In the OMB's view of life and under the Administration's budget planning, expectations are for 3%+ GDP growth in 2010 and over 4% in 2011. Although we'll have to see what happens ahead, we personally believe there is zero chance these GDP numbers will be hit. Zero. As such, the Administration's belief/projection that the US budget deficit will fall back below $1 trillion in 2010 is wishful thinking at best and probably lunacy at worst. Point being Treasury issuance over the next few years at least should indeed be well beyond current "projections". If anyone thinks the shortfall between projected Treasury issuance and the ability of the foreign community to soak up this issuance will somehow narrow any time soon, they are dreaming. Given the mosaic produced by putting all of these facts together, we see a picture of a US Fed who has just begun to monetize the Federal debt. Although we are absolutely guessing at this point, before the current cycle is over, Treasury monetization by the Fed may end up being five to six times what has already been announced and begun with the current $300 billion. That's an appetizer. Don't be surprised as this is exactly what the real numbers are pointing to dead ahead. And this of course assumes the foreign community at least keeps purchasing at levels we've experienced over the last year or so, which is no guarantee at all.
THE CHINA SYNDROME
We all know that at the margin China has been the key foreign buyer of US Treasuries over the current decade. From 2000 through January of this year, China accounted for 37.4% of all Treasuries purchased by foreign entities. As of now, they are the largest holder of US Treasuries on planet Earth, holding 24% of all Treasuries owned by the foreign sector. Bottom line? China's global capital flows at the margin are extremely important. Let's face it, it's China who could change the dynamics of what we talked about above for the better or for a whole lot worse as we move forward. They carry the largest stick and their forward actions will be the key factor influencing just how much monetization of Treasuries the Fed will necessarily need to undertake. Again, not want to undertake, but need to undertake.
The top clip of the next chart looks at actual year-by-year purchases of US Treasuries by China. 2008 was simply off the charts. Although we do need to remember that in many senses Treasury buying in 2008 was in large part about the "safety trade" as opposed to what might be seen as mercantilist economics (essentially financing the purchasing of your exports), it's hard to imagine China could again experience a 50% year over year increase in their US Treasury holdings in 2009. The estimated 2009 number we present in the chart is simply January's experience annualized. Be forewarned this is a guess at best based on one-month data. From our standpoint, there is simply no way China can keep up the level of Treasury purchases we saw last year, especially when trade flows are falling like a rock and China needs to commit stimulus funds domestically.
Finally, the bottom clip of the above chart puts China's prior purchases of Treasuries in perspective relative to total Treasury issuance over the period shown. Again, there is just no way China or the foreign community as a whole could ever dream of keeping up with current and to come Treasury issuance. The numbers are simply self-explanatory. You may have seen that just before the Geithner disguised bank bailout toxic asset plan was announced a few Monday's back, China put out a press release reaffirming their commitment to US debt purchases. Again, the numbers belie the perceptual intent of that message as new Treasury issuance will be far too large to be sopped up by Chinese purchasing. As always, watch what they do, not what they say.
Quick one. You know full well by now that the US trade deficit has been shrinking very rapidly over the last five months. In good part the price of oil is a factor, but equally important has been the literal collapse in global trade. When a country like China tells us its year over year exports have fallen by 25%, is there really a need for further explanation? We didn't think so. In short, a dramatic fall off in global trade means less dollars being "exported" and exchanged for goods and services, and ultimately less global foreign reserves that may potentially be recycled back into US financial assets. The trade related monetary "juice" the foreign community, and especially China, has in its pockets both now and ahead very simply argues for a lower level of foreign buying of total US assets, not just Treasuries. And this is exactly what we are experiencing right now and should continue to experience for some time to come.
So there you have it in terms of the short explanation as to why Fed monetization was inevitable and will continue to be ahead. The foreign and domestic communities will simply not be able to soak up all of the Treasury issuance to come. And so here we now stand with the Fed as truly the buyer of last resort, in addition to being the lender of last resort. There will be no "next buyer". Ultimately, although we're not there yet, the ability of the US to deficit spend will rest upon the ability of the Fed to monetize sovereign debt. We just have one reminder to you as we continue to move through this very special cycle, that ability is not unlimited and not without serious longer-term consequences. Of course from an investment standpoint, it's these potential unintended consequences that eat up most of our current investment thinking time.
Everything's All Right, I'll Just Say Goodnight And I'll Show Myself To The Door...Very briefly while we are on the subject, the issue of foreign capital flows and the ability of the foreign community to continue purchasing US Treasuries ahead is certainly a crucial monitor point in our ongoing assessment of US investment outcomes, but we also need to be aware of the rhythm of foreign investment in the broader US financial markets and specific asset classes. We've been through this data before so we'll just show you one updated chart. The bottom line is that the foreign community has been heavy sellers of US agency paper, corporate paper and US equities over the last four to six months. They may not be able to keep up with Treasury issuance in their Treasury buying activity, but they are literally blowing out agency and corporate debt as well as equities in as of now almost uninterrupted fashion. The current level of foreign sales of US agency and corporate paper has never been seen before in nominal dollars. Important why? As we also heard in the Fed's FOMC communiqué, they are about to print and buy back another $750 billion in MBS (mortgage backed securities) paper. This is on top of the $600B in MBS purchases they announced just a short while ago. Funny thing about monetization, once it begins it can take on a life of its own in almost geometric fashion. It's a very dangerous road to cross, but one that must be crossed at least in the land of Treasuries as we showed you above. The Fed also announced that they are considering additional purchases to include corporates and "distressed" securities. Point being, in part they fully realize that they are perhaps needing to monetize other assets being sold by the foreign community.
The chart below is a look at the longer-term foreign community purchases of all US financial assets. Interestingly, the twelve-month moving average (a measure we prefer as it smoothes out monthly "noise") peaked in June of 2007, exactly one month prior to the July 2007 Bear Sterns twin hedge fund blowups that were in hindsight the initial rumblings of a US credit cycle about to come apart at the seams. Does action of the foreign community since that time relative to their US financial asset holdings say something about trust and faith in the US financial system from an outsiders perspective?
The Road Ahead...The Fed moving into all out monetization mode is a new construct for today's investment community. We're going to be navigating ahead with few historical guideposts. The poster child reference point for quantitative easing in the modern era is clearly the experience of Japan, and that's not necessarily a comforting experiential outcome. As we're sure you already know, Japan was very late in the game in its own post equity and real estate bubble reconciliation cycle when it decided to pull the QE monetary policy trigger. As the chart below shows us, the Bank of Japan officially announced its intention to print money to buy sovereign debt on March 19 of 2001. Within a month of the announcement, the Nikkei had rallied just over 19%. Post the rally peak, the Nikkei never saw this level again for four and one half years and proceeded to lose almost 48% of its value over the next year and three quarters post the initial QE announcement rally.
But we believe there are a number of absolutely key differential points we need to keep in mind when trying to benchmark what will be significant US quantitative easing efforts ahead, as we discussed above, against the experience of Japan. In our minds THE key differential is that Japan began their quantitative easing during a period in which the country as a whole was running a very large surplus. Conditions for the US could not be a further polar opposite at the moment. Japan began their QE efforts when household savings in Japan was quite high and had been for year's prior. Again, quite the opposite of the current US circumstances. Bottom line? Japan began QE from a position of internal financial strength. The US now begins QE after not having been able to internally fund its own borrowing for many moons, being already heavily indebted and in a big deficit position. And so now deficit spending in the US is to move into hyper drive, supported in large part by Fed sponsored QE? A huge contrast point to the experience of Japan.
From our perspective, we see Japan's experience as country that chose to undertake QE as a proactive monetary policy choice. And it did so from a position of surplus and savings rich financial strength. Alternatively, as we hope we made clear above, the Fed is not moving to QE as a proactive choice or within the context of greater US financial surplus and savings strength, but is rather being forced to undertake QE as quite simply there is no other buyer large enough to finance US Treasury issuance to come. In our minds, a glaring differential and potentially a key differentiation point in terms of forward economic and financial market outcomes. Without sounding melodramatic, please do not forget these key points. We believe that to blindly assume a relatively benign outcome for the US in terms of forward interest rates, global capital flows and currency valuation, as very much was the case for Japan post embarking on QE, will be a huge mistake.
Like the initial experience in Japan, US equities have so far responded favorably to the supposedly magic drug of monetization. But we need to ask ourselves in the larger picture, can US equities build an intermediate or longer term bull market case based on the rationale of massive government deficit spending supported by a Fed that will print money to fund that deficit spending? Can it really be that within the context of the global economy of the moment, the key competitive advantage of the US is a printing press? Make no mistake about it, monetization can positively influence economic and financial market outcomes for a time. We need to respect this fact. Greenspan proved this in spades during the late 1990's pre-Y2K liquidity extravaganza in the US. As you'll remember, the NASDAQ doubled. Of course the aftermath was none too pleasant, and continues as such to this day. As we mentioned above, we believe the key to navigating the investment environment ahead is to anticipate the unintended consequences of current government spending and Fed actions. Over the years it has been our experience that the most important drivers of asset prices are not the outcomes that can be seen and/or anticipated by the many, but rather the unseen outcomes that only the few dare anticipate. Hasn't this exactly been the case since equity market highs of 2007? We believe it will continue to be so ahead.