Fed Eats Treasury

Historically the US Treasury Department has been responsible for the Dollar policy and liability management (debt issuance). Both of those responsibilities have been co-opted by Ben Bernanke.  That Treasury has let this happen speaks volumes for the lack of leadership. In my opinion Treasury is allowing the Fed to run wild while the systemic risks are rising.

The issue of exchange rate policy is, I think, clear-cut. There is a direct correlation between QE and dollar weakness. A weak dollar is a primary goal of QE. A cheap dollar policy will bring us the inflation that Bernanke keeps telling us we need.  It will also make us a pariah. This comment from the German Finance Minister at the Korean G 20 says it all.

“I tried to make clear that I regard that (QE-2) as the wrong way to go. An excessive, permanent increase in money is, in my view, an indirect manipulation of the exchange rate.”

The issue of liability management is not as clear as is the case for FX policy. Let me try. Consider this chart of existing treasury debt outstanding.

As Zero Hedge has been pointing out for weeks, there simply is not enough long-term bonds outstanding for the Fed to purchase.  

QE-Lite commits the Fed to buy Treasuries in an amount equal to the roll off of the MBS book from QE-1. Between the low rate/refi’s, repurchases of mortgages in default (20+%) and the normal turnover in homes a substantial portion of the Fed’s MBS book will run out over the next 24 months. We could push $1 trillion just from that. Then there is good old QE-2 that is staring us in the face. That number starts with $500b and goes easily to a Trillion. A reasonable estimate for the amount of total Fed POMO buys between now and 12/31/11 is $1.5 Trillion.

With that estimate go back to the graph and tell me what are they going to buy? There are few choices:

(A) The Fed could buy 100% of all existing issues from 2018 on. They could also buy up all of the scheduled new issues for the next 14 months with a maturity greater than eight years. That would come to the $1.5 trillion.  This approach would be insane.

The existence of a viable and liquid long-term bond market is a cornerstone of America’s capital market. Eliminating a substantial portion of the float for maturities ten years and longer would have negative implications for liquidity for all long-term debt issued globally. The US Treasury market has always been a benchmark from which thousands of other credit instruments are spread priced. Liquidity in Treasury issues is an essential ingredient for swap and hedging pricing. A busted Treasury market is like putting sand in all of the capital markets. Things will grind down. Liquidity will be impacted.

(B) The Fed could buy all maturities such that their purchases approximated the average life of existing US debt. This would be supremely insane.

The problem is that the average maturity is just a bit over four years.  Looking again at the chart you will see that in order to achieve a balanced purchase program the Fed would have to acquire hundreds of billions of 2, 3 and 4-year paper. Two problems:

(I)           Interest rates for these short maturities are already at historical low levels. Further reductions would starve more savers and fatten bank income statements. But they would do nothing for the housing market and the unemployment rate.

(II)         What happens in two years when $300b of bonds owned by the Fed come due? Is Treasury forced to issue more debt to the public to pay off the Fed? That would be an opportunity for the bond market to rape the taxpayers. They would have the Fed and Treasury in their crosshairs. Keep in mind that this conflict is not some time far off into the future. On the day that QE-2 is completed it will be less than twelve months more until the first maturities hit. What will inevitably happen is that Bernanke will rush to the rescue and announce that he is rolling over his holdings and will do what he has done with QE Lite. He will have permanently expanded the Feds balance sheet. He will have no other option but to do so. IMHO there is no greater systemic risk that the nation faces. We will have been forced into a policy of perpetual QE. PRECISELY WHAT BERNANKE HAS PROMISED AGAIN AND AGAIN THAT HE WOULD NOT ALLOW.

We are getting dangerously close to a trade war with our closest allies. The US weak dollar policy engineered by Bernanke has global considerations beyond short-term economics. This is a matter for the Executive Branch of government. Elected officials are responsible for this critical policy matter.  So far they have just looked the other way.

Treasury is responsible to the people for maintaining viable capital markets.  They are mandated to minimize the risks associated with bunching of maturities. Yet the Fed’s QE will clearly undermine their efforts. And they have been silent these past few months. If they were looking out for the best interest of all Americans they would have been yelling and screaming that the long-term strategic interests of the US are not aligned with a short-term bet by the Fed.

Bernanke has his foot so deep in his mouth with QE that he can’t back off and he can’t win. If he comes with some minimalist approach it will accomplish nothing, except disappointing all those who think they own a free put. He could go the other way and give us shock and awe. Thirty-six months later America will fall into a hole that will take a very long time to dig out of. Either way, QE and the Bernanke Fed will go down in history as one of the worst mistakes the country has ever made. History will not be so kind to Geithner either. As Treasury Secretary he ignored two critical obligations of his office. We will all pay a big price.