A Lost & New Decade, Part II

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February 03, 2010
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The sequel to the Active Indexer's query: In which areas will investors find strength for this new decade?

 

[For part 1 of this article, click here.]

 

Where Are TSY Buyers?

Who will buy $2.6 trillion (t) in Treasury (TSY) issuance in 2010? According to Barclays Bank, 37 percent will be bought by foreigners and
U.S.
households, 20 percent by banks and 5 percent by pension plans, all of which equal $1.6t. Thirty-eight percent will be taken off the market by the Federal Reserve Bank (FRB) and other central banks, or another $1t. Barclays also sees the FRB balance sheet topping out at $2.5t by March 2009.

In 2007-2008, foreigners absorbed nearly all of TSY issuance. Their numbers are dwindling.

Do not expect pensions to buy risky assets; they are liability-funding with bonds, as Ron Ryan of ALM, Inc. has been advising them to do for decades. Pension equity allocations declined from 60 percent in 2006 to 40 percent in 2008 and were most likely near 45 percent in 2009. Future liability mandates could drive their equity holdings to 30 percent. Individual investors, the aging boomers who were the buyers of tech-telecom stocks in the late 1990s, are also funding their retirement needs because the median boomer age exceeded 60 years in 2008. They have gone from preaching “nothing but Nasdaq” to “bonds are better than nothing.” Money market fund assets were $3.8t in 2008, $3.2t in 2009 and are estimated to be $2.5t by year-end 2010. Most of these assets are earmarked for retirement funding with bonds and for paying down consumer debts before retirement.

The FRB Is On Libor Rate Watch

The market expects the yield curve to steepen (we agree) and credit spreads to tighten (disagree) in 2010. A steeper yield curve is seen because of FRB rate hikes. I think that if the FRB does raise rates in 2010, it would do so gradually. Gradualism enables a profit spread for the banks. The FRB’s strategy could be to keep the FRB fund rates constant near 0.25 percent for a while and then hike in 0.25 percent increments until it hits 1 percent. If so, bank profits would result by the FRB holding the rate they pay on bank reserves higher than LIBOR rates.

My view is that economic weakness will delay FRB rate hikes. They will only hike rates in response to a sovereign default contagion, which might happen late in 2010 or sometime in 2011. In November 2009, the FRB was “wolfing” when FRB officials clamored about their willingness to raise rates in large doses if inflation were a threat. The FRB will trade a few years of 3 to 5 percent inflation rates for saving the banks, which smells like central planning by the
U.S.
!

Watch the three-month Libor rate vs. the yen and $U.S. dollar ($USD) rates to see who wins the race to the bottom. Carry-trade currencies become weaker relative to other currencies, because global traders borrow money denominated in low-yielding currencies such as the yen and dollar (the newest entry) to buy risky assets around the globe. Carry traders sell currencies with the lowest short-term interest rates to buy securities based in currencies with high yields or returns.

According to the Congressional Budget Office (CBO), projected
U.S.
government deficits of 5 to 7 percent of GDP are expected over the next decade. $1.4t is projected for 2010 and $1t in 2011. The red ink is expected to run below $1t for the rest of the decade. However, if the Bush tax cuts are extended, AMT indexed to CPI and if fiscal spending grows at the same rate as our GDP as it historically does, annual deficits will decline to $1.1t by 2012, but then gradually rise to $1.9t by 2019. If so then, TSY issuance might be $2.5t to $3t in 2010 and $2.5t until 2013.

 

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