Yes, People See Through US Treasury AAA Farce

♠ Posted by Emmanuel in , at 3/25/2010 06:10:00 AM
Burger King is not the only American concern that likes to sell Whoppers. Recently, we've asked "Where's the Beef?" with regard to the American Dream and the melting pot and have found both notions quite wanting to say the least. Returning to the realm of sovereign borrowing, let's turn our attention to that chestnut: triple-A "risk free" Treasuries. It seems the infinite appetite America #1-style cheerleaders ascribe to them as evidence of the Enduring Greatness of America is losing its lustre. To start with, the most recent TIC data release indicates that Chinese holdings of this stuff has fallen for a third straight month, unbeknownst to many of us as the FT summarizes; full summary here of the $33.4 billion decline in TIC flows for January:
Foreign governments and central banks sold a record amount of US financial assets in January as China continued to reduce its holdings of Treasuries, government figures showed on Monday. Demand for corporate debt also fell, with private foreign investors shedding a record $24.8bn of corporate bonds while also shying away from equities and US agency debt.

China sold $5.8bn of Treasury securities in January, the third month running that it cut its holdings. However, revisions to previous months helped it regain its position as the top holder of US government debt, overtaking Japan...Any move by China is closely watched because it is the biggest and most politically sensitive US trade partner. Mounting US debt levels and the need by the US to fund a record budget deficit have raised concerns that this may hit the US dollar and weaken demand for US assets...

“There is such an imbalance between trade and investment flows between the US and China, that it requires an increasing level of Chinese demand for government bonds,” said Michael Woolfolk, a senior currency strategist at BNY Mellon. “If China decides to stop purchases of government bonds, then we have a problem.” Analysts cautioned that the change in China’s monthly holdings was in part due to debt maturing. The US Treasury department pointed out that China’s investments often run through offshore entities, making it possible that its US investments were appearing as holdings in Britain or Hong Kong...

“It makes much more sense to look at the prices paid for US assets, rather than the quantities bought,” Capital Economics said...
Isn't it curious how the US Treasury is at pains to point out that China isn't deserting it? As per that last statement, we now observe that the yield on the ten year Treasury has recently spiked to 3.86%.

Accompanying this phenomenon is that of the swap spread turning negative and becoming more so on ten year dollar-denominated instruments. The swap spread is the difference in yield between an official instrument alike US sovereign debt and a swap rate of similar duration. That is, the swap rate represents the cost of entering into an interest rate swap where a stream of fixed income payments is exchanged for floating rate ones. In theory, this inversion should not happen since the latter bears the credit risk of institutions not borne by sovereign borrowers. Put differently, financial institutions' cost of funding, typically based on the London Interbank Offered Rate (LIBOR), should be higher than that of the sovereign given that banks aren't similarly rated "AAA".

Now there are many interpretations of why this phenomenon is occurring [1, 2, 3], but the most obvious one is that the markets do not believe Treasuries are "risk free." It is doubly head-scratching since many of the aforementioned banks are now ultimately guaranteed by the sovereign as the recent credit crisis has demonstrated (or, at least for those still around). Certainly, the inevitable debt tsunami of American issuance isn't helping the sovereign cause. Why would you want to enter into an interest rate swap, anyway? If your expectation is that interest rates are headed higher due to this unabated debt bonanza, then you can lock in current rates (the fixed component) and pocket the difference when prevailing rates rise (the floating component). More people starting to think this way should result in an even more negative swap spread.

At any rate (pardon the pun), America's well-deserved comeuppance should be something the world economy wishes for. Like in other areas of human endeavour, the US is a bully that thinks it can get away with all sorts of financial shenanigans and make others bear the costs of adjustment. Three pieces of evidence here--declining capital inflows, rising bond yields, and inverting swap spreads--suggest this abuse cannot go on forever, much as Uncle Sam would like. Others smiting down this chronic offender with undue haste is just deserts.

In the meantime, boys and girls, if you can't tell who the suckers of globalization are, they're those who invest in America.