Record debt auctions by the Treasury last week totaled $260 billion ($109 billion in Notes - not including the replacement of maturing securities in the Fed portfolio), including weak offerings of 2-year and 5-year Treasury Notes on Tuesday and Wednesday respectively. Indirect bids (some of which have traditionally been foreign official institutions) were unimpressive and fears began to circulate that the market was already saturated. Thus the surprise of many when the 7-year $28 billion auction on Thursday went well with plenty of participation by indirect bidders. While questions still remain concerning the recent reclassification of bidders that comprise the indirect category, there is still the surprise of healthy demand for these longer dated issues and this is addressed below. On a related note, while foreign official institutions have been increasing their treasury purchases, I am skeptical that the buying was from these institutions as foreign purchasers (playing it more conservative w/respect to US debt) have been net sellers on the long end. Federal Reserve custodial holdings of treasuries surpassed the $2 trillion mark last week. However, much of this is due to foreign institutions selling their 1) Longer dated treasury debt and 2) Agency debt and MBSs, replacing these holdings with shorter term treasuries.
It is important for the longer dated auctions to provide the perception of success. Investors (especially foreign official institutions) are watching the results of these longer dated auctions closely. Continued weakness will place even more pressure on the Treasury and Federal Reserve. While the Federal Reserve has no authority to lend directly to the Treasury, it has certainly been providing indirect support. Since March 25th (commencement of the Treasury purchase program by the Fed), the Fed has purchased $229.207 billion in treasury securities from its primary dealer network. More importantly, $94 billion of that debt was set to mature in about seven years or more (some of these securities were just shy of the 7-year mark ... but for our purposes is quite relevant). Meanwhile, the Treasury has auctioned $245 billion of 7-year, 10-year, and 30-year securities since the Treasury purchase program at the Fed commenced. Thus, the Fed has essentially supported 38.4% of the longer dated Treasury auctions during this time period. Is there any wonder that the 7-year auction last week went well? The Fed has been draining the supply of these securities in significant proportions on a consistent basis.
Looking at more recent activity, the Fed executed purchases of treasury securities totaling $12.99 billion maturing in about seven years or more. These purchases came on 7/21, 7/23, and 7/29, with nearly $7 billion on 7/21 coming in the form of treasuries with maturities of seven to eight years. With the 7-year debt auction on Thursday 7/30 being $28 billion, the Fed gave the market a nice head start soaking a substantial supply of longer term debt and specifically treasuries in the seven year maturity range. What is also clear is that the primary dealers purchasing the securities at auction are not holding these securities long before the Fed comes to the rescue. Let's take the 7-year 3.25% coupon Treasury Notes auctioned by the Treasury on 6/25/09 as an example. $2.722 billion of this particular issue (CUSIP 912828KZ2) was purchased by the Fed on the day of issuance (6/30/09), with an additional $3.785 billion a mere three weeks later on 7/21/09. This is not atypical as there are many examples where the Fed executed large purchases of securities in close proximity to the actual auction of those securities . On the Fed calendar this week is the purchase of some longer dated treasury securities (Wednesday and Thursday), including some with maturities of seven to ten years. I would venture to say that a sizeable stake of these securities were auctioned by the Treasury in the last couple of months, maybe even last Thursday. It makes you wonder if the Fed is not encouraging primary dealer participation in these auctions by making it abundantly clear that the Fed will absorb a sizeable portion of their inventory quickly, while still assuring dealer profits. This is about as close as it gets to the Fed lending directly to the Treasury, without actually doing it. Federal Reserve treasury security purchases can be found here ... [Permanent Open Market Purchases].
What happens when the $300 billion purchase program limit has been met? At the current rate of purchases, this will be sometime in early September. Will the Fed extend this program? A few possible outcomes ...
- The Fed does not extend the program and the Treasury continues its schedule of longer dated auctions (monthly and in consistent amounts for the 7-year, 10-year, and 30-year treasuries). Here, longer dated treasuries will fall and yields will rise, sans some unexpected reversal of investor sentiment with respect to these securities. The impact on the economy and particularly the housing market will be significant.
- The Fed does not extend the program and the Treasury cuts back on the volume of longer dated auctions, replacing them with securities of shorter duration. Here, the average maturity of outstanding Treasury debt will continue to decline, forcing the Treasury to roll over maturing debt more often. This is also much riskier for our economy in that investors will have more leverage over short term interest rates, which will also impact longer term interest rates over time.
- The Fed extends the program. Regardless of what the Treasury does, this additional debt monetization will result in more bank reserves created by the Fed and all other things being equal, an increased monetary base. Also, at some point, investors will shun these securities in larger numbers, driving longer term interest rates higher.
Revelation of the path chosen by the Federal Reserve and Treasury will not be long in coming.
