While we in the US were discussing PPIP and finally getting the automobile industry restructuring right under Steven Rattner, the first UK Treasury funding auction failed in more than seven years. On March 24, the UK Treasury tried to sell 1.75 billion pounds ($2.6 billion) of 40-year gilts and got only 1.63 billion pounds of bids, a sign that investors are reluctant to finance the UK’s record borrowing. While issues of UK inflation-protected bonds went unfilled in 2002 and 1999, it’s the first failure of non-indexed bonds since 1995.
The problem seems to be that investors are running out of money for safe assets and no longer find low yields attractive. The Bank of England cut its benchmark lending rate to 0.5 percent this month, the lowest ever, and started a program to boost the money supply. “Yields at these levels are not all that attractive,” said the UK’s Debt Management Office Chief Executive Officer Robert Stheeman.
Yet Investors bid for 2.7 times the 1.1 billion pounds ($1.6 billion) of 2022 index-linked securities offered on March 26. “It makes sense to be looking at inflation protection, hence today’s auction was a success,” said Peter Chatwell, a strategist in London at Calyon, the investment-banking arm of Credit Agricole SA on Bloomberg that day. “I don’t think anyone can argue against the fact that it’s going to be hard to control the inflationary aspect of quantitative easing and the stimulus packages.”
The issue is not unique to Britain, only the institutional designs of other countries are different. Under the German auction system, for instance, the Federal Finance Agency retains unsold notes and bonds to sell in the secondary market. Without such a system, the Federal Finance Agency reports that nine out of the 37 auctions last year would have similarly failed.
What does all this mean for the US? On March 23, the Federal Reserve took its inflation-fighting rhetoric to new levels, releasing a one-page joint statement with Treasury on the division of economic responsibilities between the two agencies. As reported by Bloomberg, the release said that while the Fed collaborates with other agencies to preserve financial stability, it alone is in charge of keeping consumer prices stable, its independence “critical.” Nevertheless, Treasury Secretary Timothy Geithner, soon stirred the pot by muttering the “H” word, asserting that the Fed’s injections of reserves into the economy are “not going to create the risk of hyperinflation in the future.”
Fueling the concern that policy makers will have a tough time if they try to end their emergency-lending programs as soon as next year while the unemployment rate, currently a quarter-century high 8.1 percent, remains at elevated levels. According to Banc of America securities this week, those emergency-lending programs have roughly doubled the monetary base over the last year and stand to increase it another threefold in the near future, from about $1.5 trillion today to nearly $4.5 trillion in the event that all the programs now enacted are used to capacity (see Figure 1). “If we have a slow recovery, which seems likely, who is going to watch them raise interest rates as the Treasury sells this mountain of debt” stemming from fiscal deficits, Allan Meltzer, said in a Bloomberg Television interview.
But even before that point, the more immediate problem is who will buy all the debt necessary to fund those programs? According to Bridgewater Associates, foreigners now own about 60% of outstanding Treasury debt and have bought 75% of issuance over the past five years. In the five years leading up to the financial crisis the Treasury only issued $250 billion per year. Tallying up all of the potential buyers in the market today, Bridgewater can only find about $580 billion in demand for Treasuries, including demand for near-funded T-Bills. While that demand would be sufficient for the previous five years’ average, it is nowhere near what is needed to buy the $2.2 trillion of issuance needed to fund bailout programs in the short term.
That leaves the U.S. two choices: either a) reduce the rate of government intervention in the economic collapse, or b) have the Fed will print enough money to buy the remaining $1.6 trillion in Treasury issuance. US policymakers show no signs of slowing intervention. Hence, that leaves it to the Fed to print the remaining $1.6 trillion, which means inflation.
Failure to realize the two choices will most likely result in failed US bond auctions in the near future. As in the UK, the failed auctions will be stimulated by an inability to sell low-yield assets with higher inflation expectations. Also as in the UK, we can expect high demand for TIPS after inflation expectations take hold. While TIPS are useful in steady state economies, they are a burden to the Treasury in inflationary scenarios. When all public and private contracts are easily indexed by TIPS high inflation can be embedded in private contracts, resulting in the type of persistent and lasting inflationary bias seen in Brazil in the 1990s and other episodes of problem inflation around the world.
Nonetheless, TIPS are still a relative bargain on today’s markets. A recent working paper by Robert Shapiro and Aparna Mathur (http://www.sonecon.com/docs/studies/Report_on_TIPS_Shapiro-Mathur_March2009.pdf) shows that in an inflationary world, a ten-year TIPS buyback would save taxpayers almost $70 billion. Furthermore, such a buyback helps end the investor uncertainty by strongly asserting that the Treasury fully expects a substantial degree of recovery and inflation in the near future, setting expectations of investment returns that can help drive recovery now, pulling investors from low-yielding defaulted securities into higher-yielding securities that fund productive new investments.
The US is not exempt from the laws of economics and market forces. We will have to realign our debt funding before the crisis is over. While certainly distracted by bank bailout policy, Treasury should start seriously considering how realign debt policy today to make sure the government remains funded through the crisis.