In Defense of U.S. Treasuries (or, Debunking an Ideological Rant)

June 26, 2012
By

As a general rule, it is wise to avoid debates on emotionally charged topics.

This extends to certain areas of trading and investing, where schools of thought take their differences as seriously as competing religions.

It also extends to certain macro topics — relating to “moral” matters such as debt, the corruption of the current monetary system, and so on — where conviction morphs into ideological zeal run wild.

We are just simple caveman traders here (with the occasional flight of theoretical fancy, like this discussion of Modern Monetary Theory).

And we aren’t all that enamored of picking fights.

But with that said: Every once in a while you come across something that is just so… so… wrong… you feel compelled to respond to it.

That was the feeling I got in respect to a new article from TheStreet.com that is making the rounds — hat tip Reformed Broker — titled Who’s Propping Up the U.S. Treasury Market?

I am surprised an outlet as mainstream respectable as TheStreet.com would run something as loopy as this. It’s so full of sloppy thinking and non sequiturs, I’m just going to indulge myself and go through it line by line (until I get sick of it).

Here we go — and again you can find the full piece here.

The U.S. Treasury market is the biggest financial mystery today.

Much like the proverbial “lead zeppelin” defies the laws of physics, the current status of the Treasury market defies all of our financial fundamentals. It is a market that cannot exist, and yet it does.

Actually the U.S. Treasury market is not really a mystery at all. There are plenty of plausible explanations for why the U.S. Treasury market is behaving as it is. There are also comparable analogues, like the Japanese Government Bond market, which has been a “mystery” (in terms of supposedly defying the laws of gravity) for years and years.

You can find many logical, coherent explanations for UST activity if you only look. This author simply chose not to look. You can also find logical cases made for those who remain bullish on USTs: Gary Shilling, Lacy Hunt, and Chris Weber come to mind off the top of my head.

Here are two quick examples from a 20 second Google search:

  • Gary Shilling: More Juice Left in Treasurys (Forbes)
  • Rosenberg, Hunt: Still Time to Make Money in Treasury Bonds (MarketWatch)

In short, there are plenty of theoretical explanations out there. And this statement — “It is a market that cannot exist, and yet it does” — shows how far afield the author is about to go.


I’m not a big Ayn Rand fan, but I agree with her advice on contradictions: If there appears to be a contradiction, check your premises. Chances are one of them is wrong.

Previously, my own writing has focused upon one particular aspect of this absurdity: the highest prices for U.S. Treasuries at a time of maximum supply. This, in itself, is an absolute financial contradiction. The highest supply in history directly implies the lowest prices in history, for every market in the world — except U.S. Treasuries.

This is pure nonsense. Supply has to be understood in the context of demand. If there is record demand, then record supply doesn’t have to imply anything.

If we have maximum supply of, say, crude oil — more barrels per day than ever before — but we also have new record demand, then prices will keep rising.

Conversely, a fall in supply says nothing if demand falls even faster. The supply of whale blubber has effectively dropped to zero. But so too has demand, so who cares.

But that is merely Act One of this Theater of the Absurd. These maximum prices are occurring at the point in history where the U.S. has never been less solvent. This also directly implies that U.S. Treasuries should be fetching the lowest prices in history — as is occurring with their deadbeat counterparts in Europe.

Are you freakin’ kidding me?

First of all, it doesn’t mean anything to say the U.S. has “never been less solvent.” The United States has the ability to repay its debts in its own currency. What this means, effectively, is that the U.S. can never go “broke” in the traditional sense of the term.

It IS possible for the U.S. to severely debase the currency — which is a form of inflation risk rather than insolvency risk, two very different things — but how much inflation do we have right now? Pay any attention to monetary velocity? Seen the price of oil lately? HELLO, MCFLY…

Re, “deadbeat counterparts in Europe” — the problem with Europe is that Spain, Greece and others borrowed huge sums in a currency they do not control. The economies of the periphery countries are being forced into severe contraction, possibly depression, because debt loads are too high and there is no access to sovereign policy response.

On top of that, the entire eurozone is in danger of breaking up… the whole project of fiscal monetary union is at risk of falling apart.

Now tell me, who thinks that the monetary union of the United States is at risk of falling apart? In fact, those urging solutions upon Europe are focusing on trying to implement what the United States already has: A coherent and stable system of fiscal governance and federal deposit insurance. Say what you will about how indebted Uncle Sam is, but the United States’ situation is nowhere near Europe’s.

No one has been able to explain this ultimate financial contradiction, and so I have previously done so myself. My solution for this conundrum was based upon the Holmesian Principle of logic asserted by Sir Arthur Conan Doyle: When you eliminate the impossible, whatever remains (no matter how unlikely) must be the answer.

Actually plenty of people have explained it…  there are plenty of coherent views available as to why, given the current state of deleveraging and macroeconomic implications of global slowdown, U.S. Treasuries are strong. This author just hasn’t bothered doing any real research.

In applying this principle to the logical/financial contradiction of the U.S. Treasury market, I was left with only one possibility: that B.S. Bernanke is secretly (and illegally) counterfeiting U.S. dollars — and using those bogus dollars to prop up the U.S. Treasury market. There is simply no other viable theory for how this “lead zeppelin” continues to (supposedly) generate the highest prices in history for this thoroughly and obviously worthless paper.

Of course there are plenty of other “viable theories,” such as:

  • Record demand for deep and liquid safe havens, at a time when such safe havens are in vanishingly short supply.
  • A willingness of foreign governments, large institutions, and individual households to trust U.S. Treasury bonds over other, less assured alternatives.
  • A focus on return “of” capital, rather than return “on” capital. If you buy treasury bonds and hold them to maturity, you will get 100 cents on the dollar back. There is a question as to what those dollars will be worth at the time you get them back, but again, this is an inflation issue (and separate from solvency concerns).
  • A concern that if the euro truly breaks up, or if the viability of the euro as an alternative world reserve currency is permanently impaired, relative demand for dollar-denominated assets will uptrend significantly (thus benefiting USTs).
  • The belief on the part of some long-term UST holders that the multi-decade treasury bull market is not over… that the forces of deflation and deleveraging are actually far stronger than the half-measure stimulating power of politically constrained central banks… and the conviction that long-term U.S. rates will actually be even LOWER before it’s all over. (Japan is an analogue here; this is the defensible argument that the U.S. is converging with Japan.)
  • A willingness on the part of China and other large trading partners to continue purchasing U.S. treasuries not out of charity, but a sense of self preservation. As the largest economy in the world accounting for roughly 25% of world GDP, the health of the U.S. treasury market is incentivized for every major trading partner and creditor of the United States.

As for secretly and “illegally” counterfeiting U.S. dollars, why would the Fed have to “illegally” counterfeit? They own the printing press!

Printing money to buy bonds is what Quantitative Easing is all about. Why would the Federal Reserve do this illegally, when they have the ability to do it out in the open — and when the bulk of stimulative effect is psychological in the first place?

Thus, I originally wrote “Maximum Fraud in the U.S. Treasuries Market” back at the beginning of this year. Since that time I have watched with interest to see if any competing theories would emerge.

Obviously I haven’t been watching the mainstream media. The same mindless parrots who report on this financial absurdity on a daily basis have never seen anything even slightly unusual about maximum supply and maximum prices occurring simultaneously. So I have been watching other members of the alternative media for such developments.

Ah, maybe this is the problem. Could he be “watching,” as in watching TV and not reading? Because the truly absurd notion is the one that says no “competing theories” are out there.

It is like an academic claiming no one disagrees with efficient market theory, because he took a poll in the faculty lounge and found no dissent.

And we’ve already touched on how pointless it is to harp on “maximum supply” without the proper context of demand…

To the best of my knowledge, only one such theory has emerged. This theory holds that the financial/logical contradiction of the U.S. Treasury market is simply a product of manipulation of interest rate swaps. Sadly, this theory appears to have been accepted by many members of this community despite the fact it is fatally flawed.

Understand that the mere (absurd) prices for U.S. Treasuries are the minor element of this mystery. The real question is and has always been: Who is buying this worthless paper?

Sigh. It just keeps getting worse. The idea that the U.S. Treasury market is “simply a product of manipulation of interest rate swaps” is simply stupid.

Look: If the Federal Reserve wanted to prop up the treasury market, they could do it. They wouldn’t even have to do it illegally. They could simply implement mass QE, i.e. printing money to buy bonds.

The thing is, though, in propping up the bond market this way, the Fed would simultaneously be forced to flood the open market with an excess supply of dollars… which in turn would cause a crash in the value of the dollar as everyone fled the currency. Because the dollar is not crashing, we can be reasonably certain that the demand for USTs is real.

And the paper is not “worthless.” Good grief, how do people get away with saying this stupid shit? As a debtor, the United States government has taxable authority over a $15 TRILLION ECONOMY!

I’d say when a debtor has the ability to tap the largest and most productive economy on the planet in the interest of servicing debt obligations, one could hardly call their collateral “worthless”… and thus it makes no sense to call the debt ‘worthless.’

I will try to resist shouting the following (and this is me, Jack, talking now):

Those who are deeply concerned with the fiscal indebtedness of the United States should be worried about the currency, not the bond market. This is because, if serious problems show up in respect to the “full faith and credit” of the U.S. government, the transmission mechanism will be a sharp decline in the U.S. dollar as the Federal Reserve prints money — LEGALLY — with which to buy bonds.

Furthermore, it is stupid and childish to call U.S. Treasury bonds worthless. One can argue that USTs are greatly OVERVALUED, yes — in the same manner a stock can be overvalued, like Coca-Cola at its peak in the late 90s — but expectations of an eventual sharp decline from an overvalued state (and commensurate rise in rates) is a far, far cry from nonsensical hand-waving about how treasury bonds are “worthless,” a “ponzi scheme,” or whatever the polemic du jour is.

Treasury bonds are backed by government taxing power on a $15 TRILLION ECONOMY and, what’s more, the United States as a debtor has a very special role in the global economy in respect to its size, military might, and key market characteristics for multiple trading partners. What’s more, given the United States’ ability to issue debt in its own currency, the prevailing risk here is inflation risk, NOT solvency risk.

At some point US Treasuries will make for one hell of a short trade — and we look forward to that trade — but again, this is comparable to the perspective of an overvalued stock seeing a meaningful price decline, NOT expecting the underlying concern to “go out of business” or any such thing.

What’s more, the transmission mechanism for concern — the U.S. dollar — and the primary drivers of boots-on-the-ground inflation — wage trends and monetary velocity — are showing NO signs of life right now, which is precisely why intelligent treasury bulls still exist (though we are not among them).

The article blathers on, but I’ve had enough.

The bottom line is, be careful with your “macro” sources — especially when the tone and tenor of a debate goes from reasoned perspective to full-throated ideological shouting.

Be intelligently skeptical and cautious prior to wholesale adaptation of anything you read — including our stuff — and watch for warning signs.

shaking his head,

JS (jack@mercenarytrader.com)

Recent Economics & Theory (scroll for archives)



5 Responses to In Defense of U.S. Treasuries (or, Debunking an Ideological Rant)

  1. mikec74 on June 26, 2012 at 6:27 pm

    Any thoughts on Treasuries in terms of an upcoming position or swing trade. Seems to me there has been a very shallow pullback and consolidation the last 15-20 trading days after that monster upmove. Perhaps setting up for another upleg?

    • Jack Sparrow on June 27, 2012 at 8:28 am

      No position in USTs at moment — high uncertainty and plausible scenarios for a next leg either way. Waiting for more clarity before getting involved again there.

  2. Jojo on June 26, 2012 at 8:29 pm

    Check these guys out – also doing great work…

    http://onlypricesmatter.wordpress.com

    • Jack Sparrow on June 27, 2012 at 8:30 am

      Thanks, will take a look – not sure I'd agree prices are "divine," but price action certainly deserves a lot more respect than it gets…

  3. web on November 5, 2012 at 10:37 am

    Thanks for finally writing about >In Defense of U.

    S. Treasuries (or, Debunking an Ideological Rant) |
    Mercenary Trader <Liked it!

Leave a Reply

Your email address will not be published.