Wednesday, August 26, 2009

At no time do my hands leave my arms

Sunday, August 2, 2009

Since the start of 2009 and continuing through the month of May, private investors sold $364 billion dollars worth of US assets, while central banks purchased $50 billion dollars worth. (TIC report)

During this past business week (July 27th - 31st, 2009), the US Treasury auctioned off more than $243 billion worth of various Treasury bills and bonds. "Indirect bidders," assumed to be mainly central banks, took an astonishing 39% of the total, or nearly $95 billion worth.

Wait a minute, thought we just talked about how the TIC report said that foreign central banks have only bought $50 billion in total US paper assets through May - and now they are said to be buying $95 billion during a single week in July alone?

Something is not adding up here.

To understand what, and to get to the essence of the shell game, we need to visit one more source of information - something called the Federal Reserve Custody Account.

It turns out that when China's central bank (or any other foreign central bank) decides to buy either US agency or Treasury bonds, they do not walk up to some window somewhere, hand over a pile of cash, and then take some nice looking bonds home with them in a suitcase.

Instead, what happens is that the Federal Reserve actually holds the bonds (or rather an electronic entry representing the bonds) in a special account for these various central banks. This is called the "Custody Account" and it holds US debt 'in custody' for various central banks. Think of it as a magnificently vast brokerage/checking account, run by the Federal Reserve for central banks, and you'll have the right image.

The custody account currently stands at $2.787 trillion (with a "t") dollars. It has increased by over $430 billion the past 12 months and by more than $275 billion in 2009 alone (through July 29). These are truly shocking numbers, and they tell us that foreign central banks have been accumulating US debt instruments throughout the crisis.

There has been absolutely no deflection in the growth of the custody account as a consequence of the financial crisis, bottoming trade, or the local needs of the countries involved. It's almost as if the custody account is completely disconnected from the world around it. We might wonder what sorts of distortions are created by having such a massive monetary spigot aimed from several central banks towards a single country. We also might question just how sustainable such an arrangement really is.

Despite everything that's been going on, the custody account is on track to grow by the largest dollar amount on record this year, nearly $500 billion dollars (if the current pace continues). Where is all this money coming from and for how much longer?

The TIC report only shows $50 billion in foreign bank inflows for 2009, while the custody account grew by $277 billion.

How is it possible for the TIC report to show smaller inflows than growth in the custody account? One explanation is that the custody account, at some $2.7 trillion dollars, is accumulating a lot of interest. If those interest payments are not "sent home" and remain in the account, then the account will grow by enough to more or less explain the difference. For example, the $135 billion difference shown above could be generated by a 5% return to the custody account, which is not an unthinkable rate of interest for that account.

In this game, Central Bank A prints up a bunch of money and buys the debt of Country B. Then the central bank of Country B prints up a bunch of money and buys the debt of Country A.

When we dig into the custody account data, we find that the total picture is hiding something quite extraordinary. Even as the total custody account has been growing steadily and faithfully, the composition of that account has been changing dramatically.

Here we note that agency bonds peaked in October of 2008 at nearly a trillion dollars but have declined by $178 billion since then. Treasuries, on the other hand, have increased by over $500 billion over that same span of time. A half a trillion dollars! If you were wondering how the US bond auctions have managed to go so smoothly, here's part of your answer.

What is going on here? How is it possible that central banks are buying so many Treasury bonds, at the fastest rate of accumulation on record?

It would appear that foreign central banks have been swapping agency bonds for Treasury bonds, but that's not how the markets work. First, they would have to sell those bonds, before they could use the proceeds to buy government debt. So to whom did they sell those Agency bonds in order to afford the Treasury bonds?

Here we might recall that the Federal Reserve has been buying agency bonds by the hundreds of billions.

These are the three critical points to remember :

The US government has record amounts of Treasuries to sell.

Foreign central banks, which have a big pile of agency bonds in their custody account, would like to help but want to keep things somewhat under the radar to avoid scaring the debt markets.

The Federal Reserve does not want to be seen directly buying US government debt at auctions (and in fact is not permitted to, but many rules have been 'bent' worse during this crisis), because that could upset the whole illusion that there is unlimited demand for US government paper, but it also desperately wants to avoid a failed auction.

For various reasons, the Federal Reserve cannot just up and start buying all the Treasury paper that becomes available in record amounts, week after week, month after month.

Instead,it uses this three-step shell game to hide what it is doing under a layer of complexity:

Shell #1: Foreign central banks sell agency debt out of the custody account.

Shell #2: The Federal Reserve buys those agency bonds with money created out of thin air.

Shell #3: Foreign central banks use that very same money to buy Treasuries at the next government auction.

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