This note was originally published January 21, 2011 at 15:46 in Macro
Conclusion: We believe U.S. Treasury issuance over the coming three years could be ~34% higher than expectations. Increasing supply is bad for price.
Position: Short Treasuries via the etf SHY
On a very basic level, supply and demand set the market price for any good, commodity, or product that is “traded”. So, as supply increases, demand must match it, or price will decline. Obviously in practice, especially when trading the global financial markets, it is slightly more complicated. That said, large moves in either future demand or future supply still do matter. As it relates to Treasuries, we believe future supply will be much higher than consensus expects primarily because the U.S. deficit will be higher than expected.
Currently, the Congressional Budget Office (CBO), which we consider consensus for this purpose, projects that the federal budget deficit for 2011, 2012 and 2013 will be $-1,066BN, $-665BN, and $-525BN, respectively. This is a combined deficit of $-2.3TN. (Yes, that is a big number.) So, all else being equal and setting aside any maturities, the United States will have to issue $2.3TN in treasuries to fund the CBO’s projected budget deficit over the next three years. So if we accept that there is ~$14TN in government debt outstanding (Source: usdebtclock.org), then the outstanding government debt over the next three years will grow 16%. That is, supply is going up. Given this outlook, it does make sense that interest rates on 30-year Treasuries are moving higher, as noted in the chart below.
Interestingly, we think that the CBO’s budget deficit projections are low, and perhaps meaningfully so. Currently Hedgeye’s U.S. budget deficit projections for 2011, 2012, and 2013 are $-1.2TN, $-1.0TN, and $-0.9TN, respectively. Combined, this is a total deficit for the ensuing three years of $3.1TN. In aggregate, our projections are $800BN more than the CBO, or 34% higher for the three year period. The implication being that the issuance of U.S. Treasuries may be almost 34% higher than “consensus” expects over the coming three years. No doubt some of this is priced in, but our models have supply growing at an accelerated rate relative to what is likely priced in. And the questions remains, who is going to buy these treasuries?
Increasingly, of course, foreigners will have to buy more Treasuries, which is geopolitical risk for U.S. sovereignty. We highlighted this risk in an Op-ed to Canada’s Globe and Mail, where we wrote:
“Dependence on foreign oil is a real economic and strategic risk for the United States, but what about the risk related to its dependence on foreign debt financing? The combination of a low domestic savings rates and lack of government savings (that is, a massive deficit) means that the U.S. will continue to rely on foreign financing to bridge deficits well into the future.”
As we reviewed the most recent TIC data, it is clear that the amount of foreign buying is increasing. In fact, foreign ownership is up 16% y-o-y. So, which nation is buying all this U.S. debt. Well, the answer is unclear. In the chart below, we’ve highlighted the nation that appears to be buying the bulk of his new issuance . . . the United Kingdom. “UK Holdings” has increased their holdings of U.S. Treasury Securities by $356BN year-over-year, which is growth of 229%! In reality, it isn’t the United Kingdom buying the Treasuries, but other sovereignties buying debt through the United Kingdom. Most likely the Chinese, who have to continue to buy U.S. dollar paper to maintain their exchange rate at parity.
Increasingly as the U.S. funds its deficit with more Treasury issuance, investors will undoubtedly demand higher rates. Along with this, if the Chinese are indeed saying one thing, that is questioning the value of Treasuries, but continuing to buy via “UK Holdings” then the global market for U.S. Treasuries becomes even murkier, which can’t be positive for price.
Daryl G. Jones