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The $700 Billion U.S. Funding Hole; Desperately Seeking A Very Indiscriminate Treasury Buyer

Submitted by Tyler Durden on 01/24/2010 03:15 -0400

A month ago we observed that in 2010, the supply/demand picture for US fixed income would be very problematic, as there was no immediate apparent substitute to fill the void resulting from the departure of the constant bid provided by the Federal Reserve's Quantitative Easing in both the UST and the MBS markets. The conclusion was that there would need to be a dramatic increase in demand for debt securities across the board, with an emphasis of Treasuries and MBS.

Today, we focus on the most critical segment of debt issuance for 2010 - those ever critical US Treasuries, without whose weekly uptake by various investors, the multitrillion budget deficit will become unfundable. Using estimates from Morgan Stanley for 2010 Treasury supply and demand, the conclusion is that there will be a demand shortfall of at least half a trillion, and realistically $700 billion, to satisfy the roughly $1.7 trillion in net ($2.4 trillion gross) coupon issuance in the upcoming year.

The implication is that back end prices will decline sharply due to an ever increasing supply overhang, even as nearly $800 billion in Bills are paid down, thereby further accentuating the steepness of the bond curve. And with ever more emphasis put on the coupon supply, the marginal yield on long-dated Treasuries will likely find it needs to be increasingly more attractive to find bidders, which in turn will jar mortgage rates out of hibernation. We are now certain that Q.E. will continue: the weakness in the mortgage backed-market is already becoming a topic of contention, and when it becomes apparent that there is an additional $700 billion demand void in Treasuries, then it is merely a matter of time before Ben (or his successor) realizes the dollar destruction comeback tour has to resume asap. Those cynically inclined may wonder why Bernanke's reconfirmation should take place prior to any potential Q.E. 2 announcement. Perhaps this country's Senators would further evaluate their support of the Chairman once they experience the popular anger which will accompany the next leg down in the US currency the minute Mr. Bernanke announces that the Fed will need to continue being the market in treasuries and mortgage backed securities, further eroding the collateral behind the greenback.

First, based on Morgan Stanley's expectations, and further corroborated by yesterday's disclosure that the next increase in the debt ceiling by $1.9 trillion net, to $14.3 trillion, would last the country only through early 2011, we present the estimated supply of gross coupon issuance in the upcoming fiscal year (keep in mind one quarter of issuance has already been absorbed and the run-rate validates the projections).

After issuing a $1.9 trillion gross amount of coupons in F2009, in 2010 this amount is expected to increase by 30% to $2.4 trillion, with an emphasis on long-dated maturities: per the chart above, the average age of new gross coupon issuance (excluding Bill impact) will increase from 5.9 years to 6.4 years in 2010.

In 2010, net issuance will be substantially lower than gross according to MS, due to an increase in maturities, and "only" $1.7 trillion in net new coupon bonds, $425 billion more than 2009, are expected to be issued by the US Treasury: this number may well be an underestimation as the Senate, which likely has far more granular issuance projections, is calling for $1.9 trillion in net issues (in addition to the $300 billion temporary increase which passed late last year) which would fund the US budget for about a year. One offsetting feature of net issuance in 2010 will be a surge in paydowns in Bills, which are expected to be a net negative contributor to issuance to the tune of $775 billion (of which $275 billion has already taken place in Q1 of fiscal 2010, primarily as a function of the $195 billion in SFP bills rolling off).

So far so good- the supply picture is clear, and in reality the final amount will probably end up being substantially higher than $1.7 trillion net, as the runaway deficit-creating machine in D.C. will stop at nothing to prove that any one failed auction will destroy this country.

Where things get tricky is on the demand side.

As we pointed out previously, the number one defining feature of 2009 was the Fed's blatant support of the bond and MBS markets. Bernanke monetized $300 billion in Treasuries, and indirectly will have purchased another $1.4 trillion in bond/MBS hybrids (we say indirectly, because Fed MBS purchases effectively allowed MBS holders to switch their holdings to Treasuries at preferential terms, better known as the "reallocation trade" in essence achieving the same effect as if the Fed has purchased these - see Bill Gross). With the Fed out of the demand picture (at least temporarily), the questionmarks emerge.

Combining the supply and demand for Treasuries yields the following chart. Fact: in 2010, a best case of demand projections, indicates there will be a $400 billion shortfall for total Treasury supply... and a worst case of a stunning $700 billion funding shortfall. This is "just" a little worse than Greece, yet the latter's CDS trades trades nearly ten times wider than the U.S. Logical? You decide.

The key variable in this exercise is quantized and overall demand, which is why a detailed analysis of each end segment must be performed to understand the demand mechanics.

Foreign Accounts

On December 31, 2009, a majority of U.S. debt (marketable Bill, Coupons, TIPS) was held by foreigners, making America a net foreign creditor nation. Compare this with Japan, where 93% of sovereign bonds are held by domestic accounts. Yet over the past several years, the US has become increasingly reliant on foreign generosity: foreign demand has grown from $143 billion in 2007 to $794 billion in 2009. And even as foreigners have purchased an increasingly greater amount in absolute terms, the relative composition has in fact declined in the past year: foreign demand dropped from 76% in 2008 to 46% in 2009.

An even more granular analysis of foreign purchases, indicates that as foreigners rushed into the safety of Bills, demand for coupons actually declined. Also notable is that foreign demand for coupons has never moved too far, and has stayed in the range of $192-$370 billion each year.

The biggest problem this data indicates is that foreign demand will not go willingly with the Treasury's demand to extend the average Treasury maturity from 4 to 7 years: foreigners purchased 145% of the Fiscal 2008 net issuance of $255 and a meager 26% of the Fiscal 2009 of $1,271 billion.

And herein lies the rub, as MS points out, the foreign bid is usually a direct function of the amount of global trade and the associated trade gap experienced by the U.S. Historically, the excess trade gap was not an issue, as China, Japan and net exporter partners had to recycle their otherwise useless dollars back in the U.S., and they did so by purchasing U.S. bonds, thereby allowing U.S. consumers to borrow ever cheaper and to purchase yet more Chinese and Japanese trinkets, rinse, repeat.

As Zero Hedge pointed out some time ago, the deputy governor of the PBoC, Zhu Min, said the most logical, yet scariest, thing for the US Treasury.

"The United States cannot force foreign governments to increase their
holdings of Treasuries," Zhu said, according to an audio recording of
his remarks. "Double the holdings? It is definitely impossible."

"The
US current account deficit is falling as residents' savings increase,
so its trade turnover is falling, which means the US is supplying fewer
dollars to the rest of the world," he added. "The world does not have
so much money to buy more US Treasuries."

Zero Hedge has previously demonstrated the problem associated with China's trade surplus, which while still positive, saw a significant drop from the prior year. And compounding this is the concern that while China is still accumulating FX reserves, it may now be diversifying its US-denominated holdings. Yet setting diversification concerns aside, the bigger picture indicates that China UST purchases usually are a function of FX reserves: should the US continue on the recent protectionist path, this will implicitly make Chinese demand for Treasuries even scarcer.

Based purely on global trade surplus/deficits, it is likely that the foreign bid would purchase $300-$400 in coupon Treasuries in 2010. However, in evaluating foreign demand in 2010 one has to consider the Bill/MBS reallocation trade. A big question mark for 2010 will be whether foreigners will reinvest Bill holdings purchased at an above average rate in 2008 and 2009 (see Foreign Bill Vs Coupon Purchases). The demand for Bills occurred due to reallocation away from Agencies/MBS and corporates, which can be seen from the below chart. Here it becomes visible why the Fed's MBS program was the practical equivalent of a Treasury QE extension. The Fed was acquiring foreigners' MBS and Agencies at prices that would allow them to buy Bills (and sometimes Coupons) in kind.

With non-Fed demand for MBS still non-existent (and, in fact, everyone selling into the Fed's bid), and a reduced issuance of Bills in 2010, it remains to be seen what assets foreigners will reallocate to. This "reallocation" trade will likely add another $200 billion to the $300-400 billion estimated above, thus bringing total demand for Coupons to $500-600 billion, offset by a Bill outflow of $300-400 billion.

Household Sector

Recently the "Household" sector as defined in the Federal Reserve's Flow of Funds, attained some notoriety after, as Zero Hedge disclosed first, Eric Sprott brought up allegations of covert monetization and general ponziness by the Fed via the "Household" sector. We will stay away from semantics, and present what is known: at the end of 2009, "households" held 12% of Treasury debt, or $800 billion: less than a quarter of Foreign holdings of $3.6 trillion. The inappropriately-named household sector consists of individual households, nonprofits, hedge funds, private equty, private foundations, labor unions and others, and Treasury holdings allocated to it, are calculated as a differential between total USTs outstanding and known amounts held by other investors. Basically, it serves as a plug to "everything else."

Regardless of semantics, a critical point must be added to the Sprott analysis, and also to Goldman's optimistic outlook on bonds, which is predicated on increased household purchases. As a reminder, Goldman speculates:

Increased saving by households and businesses creates a
potential demand for Treasury securities as well as less competition
for lenders' funds; flow of funds data and bank balance sheet reports
confirm that the domestic private sector is increasing its allocation
to Treasury securities.

Is Goldman overly optimistic on their expectation that U.S. households will finally do what their Japanese equivalents have been doing for decades? The answer is yes. But before we get into this, we need to point out that the recent surge in "Household" buying has not been effected in one bit by actual households and individual investors. Why is this? After all, the household savings rate has increased from 0.8% in April 2008 to 4.8% in December 2009. Yet as a reminder, the two key components of Household Treasury holdings include Savings Bonds, which are what households actually buy when they wish to purchase government debt, and Other Treasuries, which are marketable Treasuries, and which average households have no access to. It is a notable observation, that while the savings rate has indeed increased, holdings of savings bonds have not only stayed flat, but have declined over the past year: this is perfectly explainable by the combination of an increasing savings mentality coupled with a desire to deleverage: i.e., Rosenberg's new frugal normal. Goldman, which has bet the house on household Treasury purchasing to keep rates low, will be disappointed.

The chart below demonstrates the historical holdings progression between Savings Bonds and Other Treasuries. As can be seen, actual households have not been active purchasers at all in the recent bond buying spree.

Yet while it will take much more to convince Goldman in its faulty assumptions, what is without doubt, is that the same "reallocation" trade that has taken place in Foreign purchasing, has been paralleled in the Household sector. As the chart below shows, while Treasury holdings have surged over the past year, this has been purely a function of a collapse in Agency/MBS holdings. In fact, in the past year, MBS holdings in the Household category have fallen by a stunning $772 billion, from $840 billion a year ago to just $68 billion most recently. This has been accompanied by a less than half increase in Treasuries in the last 12 months: from $493 billion to $860 billion, a $367 billion increase, and less than half the decline in MBS.

Just like the reallocation trade has been critical to spur demand in foreign purchasers for USTs as they have rotated out MBS with the Fed lifting any and all foreign offers, so has the Fed been busy domestically. Comparing the action over the past 3 years, from the peak of the housing bubble (2006-2009 period), indicates that the reallocation trade accounts for nearly a dollar-for-dollar move out of MBS, which declined by $352 billion from $420 billion to $68 billion, into Treasuries, which in turn increased by $344 billion, from $516 billion to $860 billion.

With just $68 billion left in Households' MBS holdings, the reallocation is over, which means that the household sector will no longer be a major purchaser of Treasuries, and all of this on the backdrop of actual consumers, whose Saving Bonds holdings have dropped from $197 billion to $192 billion over the past two years. On the other hand, should "Households" end up purchasing substantially more than expected, then the Sprott thesis will have to be seriously revisited.

Commercial Banks

A major wildcard for 2010 Treasury demand will come from commercial banks, whose $1+ trillion in excess reserves, courtesy of flawed monetary policy, may be used if not to spur consumer lending, then at least to acquire treasuries. As was shown previously, banks held only $200 billion in Treasuries at the end of 2009, making them the second to last holder, yet the massive dry powder on their books, as well as possible political prerogatives, will likely make this sector a major purchaser of Treasuries.

Empirically, banks add to their Treasury holdings at the end of recessions, when banks have capital to allocate, yet consumer and small-business loan opportunities remain weak. This can be seen on the chart below:

This is also evident when one considers that change in bank UST holdings, compared against the steepness of the yield curve: it makes all the sense in the world that banks would increase Treasury holdings in a steep yield curve environment.

Yet even if banks unleash the full power of their excess reserve holdings it will likely not do much for back end supply. The reason is that banks traditionally purchase USTs in the 2-4 year sector, as they get most of their duration via their mortgage holdings, and with rising rates, existing duration has grown. As banks receive much better returns by lending direct, moves along the curve are i) rare and ii) merely placeholder measures until the economy improves, which explains their unwillingness to stray far on the back end of the curve.

The reason why this may be problematic is that there is an incremental $350 billion in new gross issuance in the 5Y - 30Y part of the curve alone, which is precisely the part that is least attractive to the banking sector.

Another major concern to banks is the prevalent uncertainty about possible future inflation: the Fed's liquidity spigot is as worrying to banks as it is to all but the staunchest deflationists. Today, inflation uncertainty is near decade highs. Furthermore, even as 10 Year yields remain near all-time lows, 10 Y inflation expectations are rising fast.

In order to determine the pace of Treasury purchases, a comparison with prior recessions (including those of the 1970s, 1980s, and 1990s) indicates that following major recessions, banks increase their UST holdings by 1.6% to 2.7% of total assets (with an average increase of 2.2%), and this increase takes two years on average.

Of the $16.9 trillion in total banking assets as of June 2009, USTs accounted for $141 billion or 0.8%. Growing this number in value to 2.2% of projected total bank assets of $18.6 trillion in June 2011 in the low case, and 2.7% in the bear case, implies that between $421 and $513 billion in Treasuries would have to be purchased over the next two years. As $82 billion was purchased in H2 2009, this implies banks need to ramp up purchases to $225 billion per year in the low case, or about $4 billion per week. This represents about one-third the pace with which the Fed was monetizing/buying back bonds in 2009. The high case corresponds to an annual pace of $287 billion per year, or $6 billion per week: about half of the Fed's rate of purchases. Both cases, as noted above, would focus on Treasuries in the front-end of the curve.

As a result, it is expected that banks will purchase between $190 and $240 billion in Treasuries in 2010, which number also includes the $24 billion already purchased by domestic banks in Q1.

Broker-Dealers

Broker dealers, unlike the other mentioned purchasers, do not have an outright preference for Treasuries as a yielding instrument, but merely as a hedge for spread-product books (including corporates, CDS, MBS and agencies). As banks deleveraged in 2008 and 2009, they covered massive amounts of UST shorts as they sold off the underlying hedged securities. Indeed, in Fiscal 2009, B/Ds purchased a record $119 billion of Treasuries, following $86 billion in 2008. Not surprisingly, these coupon purchases occurred in the front end of the curve (1Y-5Y), again indicating B/D's aversion toward dated paper.

As of June 2009, the B/D deleveraging process appears to have ended, and in fact has reversed as leveraging has once again commenced: B/Ds sold $21 billion of Treasuries in Q4 2009. Therefore, Broker Dealers are expected to sell $25-50 billion in coupons in 2010.

Insurance/Pension Funds

Insurance funds are essentially banks-lite: they prefer to purchase treasuries in a steep yield curve environment. In 2009, insurance/pension funds were the fifth largest buyer of Treasuries ($56 billion from insurance firms and $37 billion from pension funds). With expectations of a steep yield curve (for now) likely staying in the 270-280 bps range, Insurance funds are expected to purchase about $100-$150 billion.

An upper ceiling to purchases is likely to come from the discount rate on defined benefit pension plans (around 6.5%), implying the yield on purchased Treasuries has to be at least 5.25%. Currently the highest yielding P-STRIPS in the 30 year sector offer just 5%. Insurance companies could very well become a purchasing force... however at materially lower levels.

Mutual Funds

In 2009 the fixed income mutual fund/ETF space saw unprecedented activity: doubling the $104 billion in 2008 inflows (2009 closed at $204 billion). Yet the vast majority of this amount went to chase higher-yielding, riskier assets: only $33 billion (16%) was allocated for UST purchases.

As allocation to these buyers seeks to outperform benchmarks, the allocation to USTs has traditionally stayed limited, and as a result 2010 demand from mutual funds/ETFs is expected to stay in line at around $50-75 billion. Furthermore, as has been repeatedly pointed out, equity inflows have been negative in 2009. If there is a reallocation trade whereby investors seek even riskier assets, 2009 could see a rotation out of broad fixed income into equities and even riskier assets (CDOs are already stirring).

Money Market Mutual Funds

As money-markets only invest in ultra-short dated Treasury products, this demand category would not have an impact on the back-end. Furthermore, money-markets will probably continue to unwind the $332 billion in front-end paper purchased in Fiscal 2008: already last year $34 billion in Bills and short-end coupons was sold. If ZIRP persists, and if the Volcker doctrine manages to make money markets sufficiently unattractive, this category will at best have a neutral impact on USTs and more realistically will continue to be a net seller. As such, in 2010 this segment is expected to sell $100-200 billion in Bills and front-end paper.

Municipalities

Municipalities are expected to provide a token amount of demand, to the tune of $25-50 billion: this source of demand is low in a rising rate environment. In 2009 only $3 billion in demand came from money market funds.

Federal Reserve

Up to this point, we have demonstrated that under realistic assumptions, the traditional buyers of Treasuries will be insufficient to plug the demand hole. As the Fed will not sell any of the roughly $770 billion in Treasuries on its balance sheet with a ZIRP policy still in place, the only question is whether Ben Bernanke will step in and roll out QE 2. Of course, the implications to the stock and currency markets will be drastic should the Fed relapse to its old financial heroin-dispersing ways.

Conclusion

While near end supply will likely not be as difficult to satisfy, the back-end will face increasing yield pressure in order to stimulate demand. This means that long yields will begin a slow trickle higher to attract the missing demand that currently is unaccounted for. Should this happen, and should the likes of Morgan Stanley be correct in expecting even further steepening, the implications on mortgages will likely be severe. Which is why we are confident that the Fed, which is all too aware that the economic situation is far worse than what is presented in the mainstream media, will expand quantitative easing not only to more MBS purchases (mostly to facilitate yet more reallocation trades), but to direct Treasury purchases once again. In doing so, the Fed will surely short-circuit the market beyond all repair.

A practical idea on how to approach this binary outcome, would be the implementation of the kind of barbell trade that has made John Paulson a billionaire: should the Fed announce QE 2, the dollar will plunge, and gold will surge. Due to negative convexity between these two asset classes, we anticipate a non-linear acceleration in the price of gold compared to the DXY. Alternatively, should the Fed stay pat and do nothing to prevent the verticalization in the yield curve, the other side of the barbell would be to reward those who would benefit the most from the resultant even greater curve steepness, expressing this with long financial exposure (the more levered, the better). Another levered way to play the increasing curve steepness would be putting on the Julian Robertson-proposed Constant Maturity Swap trade (discussed previously in depth here).

Lastly, should the Fed attempt to stimulate an endogenous flight to safety and boost demand for Coupons artificially, we believe, as we have said before, that the FRBNY will certainly implement a stock market crash. The alternatives, an interest rate hike and QE. We believe that while the probability of QE 2 is increasing with every day, the likelihood of a rate raise is negligible, leaving the market crash theory as the wildcard. We will not handicap this outcome and instead let every reader decide for themselves. Nonetheless, as this week demonstrated all too well, once the market gains downward momentum, even the much expected daily offer-lifters may be mysteriously elusive. Hedge appropriately.

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Sun, 01/24/2010 - 15:27 | 204635 ozziindaus

Here's a quick solution that can be implemented by 2011. Call it the New 5 step 5 year plan.

Nationalize all the TBTF's and any other institution accepting TARP even though it's been paid back.
Liquidate all the assets to fund the nations debt requirements for the next 5 years.
Cap all future debt programs as of this minute. Health care, SS, QEII......
Invest the excess in innovation, technology and manufacturing.
Set the US back on the path of global competitiveness rather than scandalous ponziness.

Sun, 01/24/2010 - 15:59 | 204673 Anonymous

sounds pretty logical and perhaps it might work. but in this case, they are not interested in solutions to this crisis, because this crisis was brought on us, in purpose as part of a specific plan, the intentional degradation and destruction of the united states and its middle class, because we are impediment to world government. so they must bring us down third world status. make sure you know this. they are not interested in fixing anything. they are not interested in our national interest. they are not the least bit interested in this country, or liberty or freedom. they could care less. what they do want is world government and they will stop at nothing to accomplish this, in their lifetimes. they have worked for this goal for a very long time, and it would appear they are pushing hard in this generation to see it come through. these scumbags must be stopped by any means necessary.

Sun, 01/24/2010 - 21:33 | 204897 boiow

+1 except for the 'any means necessary 'bit . how can anyone flag this post as 'junk'.

Sun, 01/24/2010 - 21:47 | 204902 strike for retu...

It can be marked as junk because some things are too scary to be believed.

www.ae911truth.org

Mon, 01/25/2010 - 01:01 | 205045 Hysteria

Exactly. Everything makes sense when you understand the plan.

Poverty of the masses is the tool used to keep the oligarchy in power. As Orwell, privy to the Fabian Socialist elite methods, explains in 1984:

“From the moment when the machine [capitalism] first made its appearance it was clear to all thinking people that the need for human drudgery, and therefore to a great extent for human inequality, had disappeared. If the machine were used deliberately for that end, hunger, overwork, dirt, illiteracy, and disease could be eliminated within a few generations. But it was also clear that an all-around increase in wealth threatened the destruction... of a hierarchical society. In a world in which everyone worked short hours, had enough to eat, lived in a house with a bathroom and a refrigerator, and possessed a motorcar or even an air-plane, the most obvious and perhaps the most important form of inequality would already have disappeared. If it once became general, wealth would confer no distinction. Such a society could not long remain stable. For if leisure and security were enjoyed by all alike, the great mass of human beings who are normally stupefied by poverty would become literate and would learn to think for themselves; and when once they had done this, they would sooner or later realize that the privileged minority had no function, and they would sweep it away. In the long run, a hierarchical society was only possible on a basis of poverty and ignorance... It is deliberate policy to keep even the favoured groups somewhere near the brink of hardship because a general state of scarcity increases the importance of small privileges and thus magnifies the distinction between one group and another.“

Mon, 01/25/2010 - 10:38 | 205205 Rusty Shorts

- Best post of the day anon #204673.

Sun, 01/24/2010 - 16:15 | 204686 suteibu

There you go. The answer to too much government intervention in business is more intervention. I can't believe no one thought of that before.

Sun, 01/24/2010 - 16:29 | 204697 ozziindaus

Now that's intervention I can believe in. TARP, MBS, GSE and other interventional policies have added shit to zero jobs, raised the debt ceiling and placed us deeper into consumer culture status. But I do agree with the comment below. It's not the governments interest or intent to enrich the lives of it's citizens. Any leader who thought and acted otherwise, met Lead quickly.

Sun, 01/24/2010 - 16:47 | 204709 suteibu

The problem is the selective enrichment of citizens. You want new technology and innovation, make it easier to raise capital in the free market rather than picking and choosing the company (GM) or the industry (green) to prop up with taxpayer money.

Sun, 01/24/2010 - 16:30 | 204700 Seer

Invest the excess in innovation, technology and manufacturing.

We HAD "innovation," that's what led us to this point (thanks economic wizards)!

Technology is but words on paper without physical resources. Not going to get people to go along with (the overwhelming majority) being dirt poor so that you can use precious resources to manufacture stuff for trade (which is the only way to get out of debt).

Set the US back on the path of global competitiveness rather than scandalous ponziness.

The US's competiveness was due to its being at the forefront after WWII, it being the leading oil exporter (money in) and everyone else being devastated and unable to have much in the way of manufacturing happening. Oh, that and (later) the CIA. But now that the US is a massive importer of oil (money out) it cannot be competitive unless it turns its masses into dirt-poor slaves (otherwise couldn't compete with China, who has been handed over a lot of the competiveness thanks to profit-seeking US corporations).

Sun, 01/24/2010 - 17:33 | 204744 ozziindaus

Agree with everything you're saying. I've been spouting about the same deliberate corporate charades (GM) for years now. It takes government and corporate collusion at the highest level to achieve the level of wealth transfer witnessed since the 70's and especially over the past decade.

The innovation I'm talking about (I know you're being sarcastic) are military secrets that the public can benefit off such as we've seen with the internet and GPS. I know there are many such technologies ready to propel the US into another technological boom. It's all a matter of what intergovernmental fixes are already in that may stifle them.

Sun, 01/24/2010 - 19:26 | 204817 kurt_cagle

Innovation is, by its very nature, deflationary. Double the speed of a processor and you've effectively replaced two computers with one. Provide a new medical breakthrough and fewer people get sick, reducing the amount of money to be spent on health care. Make energy systems more efficient and you spend less on raw resources in order to achieve the same gain. Make it possible for a ten year old to publish on the web and eventually the money to be gained by being a gateway to the news drops dramatically as you become just another voice.

Innovation by itself may improve the quality of life, but only if the fruits of that innovation are distributed equally. In most cases they aren't, but rather benefit investors at the expense of wage earners (as a side note, once you start awarding a disproportionate number of stock options to a manager, they have become an investor - it is not in their best interest to see the profit margin of the company reduced by taking on more employees).

Twenty years ago, producing a quality sales presentation would take a team of between ten and twenty people a week of work. Today it takes a single person perhaps a couple of hours to do the same thing. The sum of those innovations means that there's been a 500 fold increase in productivity. Put another way, there's 500 times less money that would have been injected into the economy, with the corresponding profits going not towards increasing workers' salaries but providing outsized returns on investment.

Some of this is made up by being able to do other things faster, but there is also a limit at which point demand no longer matches supply. If you have the ability to produce 100 widgets an hour pre-technology and increase that to 1000 widgets an hour post-technology, there is no guarantee that there is a demand for more than perhaps a few hundred more, at which point you end up reducing prices (deflation occurs).

The US economy was not always a growth economy. This only really occurred after World War II, when you had a rapidly rising population all entering child-rearing age at the same time, and people were purchasing new homes, new cars, furniture, taxing themselves to build schools (and later universities). That there was money to do so helped of course - the US was the primary player in the world's financial system at that point, and the holder of the reserve currency, as well as being the primary net exporter of oil.

Today population growth has slowed dramatically (and would be below the replacement rate of 2.1 if it wasn't for immigration), a significant amount of those same people buying in the 1950s and 60s are now retiring and moving into fixed income investments, house purchases are deflating naturally as people move away from MacMansions into smaller, more affordable homes, and, of course, we are now the world's largest oil importer.

Most people have enough to satisfy their basic needs of non-food goods (I have four working computers in my house, three printers, scanners, and other assorted electronic good detritus, four DVD players, three TV sets (most of which are no longer watched except when we view things as a family rather than watch over the computer) and so forth. While some of those do eventually wear out of become too slow to work with new software, the demand really isn't there to wholesale replace most of this. I suspect this is true for many other people as well.

Thus, more manufacturing isn't going to solve anything, because demand is simply no longer there. Becoming more competitive isn't going to make much difference either, because most other countries are in the same boat. Food is still necessary, of course, as is oil (though not as much of it), but beyond these two factors, there's actually comparatively little demand for manufactured goods beyond those necessary to maintain replacement levels. That's what few people, even those who make policy, understand. You can stimulate artificial demand only so far before you oversaturate even that market.

So, no, becoming more competitive is not the answer. Rethinking our approach to the economy is.

Sun, 01/24/2010 - 20:06 | 204847 ozziindaus

Technology, through innovation, in some cases, creates demand where it didn't exist. This is not just replacement of redundant technology. Think about all the new products and services that have emerged over the past few years that no one had ever imagined before. Ideas lie on a exponential curve. So although I agree that technological improvements are deflationary, technological breakthroughs demand a premium. i.e. Apple iPhone and PayPal are some examples proving that although similar products and services existed, the market was still able to raise the premium for their use.

Mon, 01/25/2010 - 13:29 | 205396 Seer

the market was still able to raise the premium for their use

But much of this was the boom or tail of the boom period.

And, as I've been repeating, there's the effect of "economies of scale" working in reverse. Most of the latest sales in non-essentials have been fire sales, which border on dumping.

Increasing unemployment further places stress on disposable income. On the whole, the market for innovated products is shrinking: commodities, on the other hand, will always have a market.

Lastly, about "innovation," I think that we make it into more than it really is. Much of the trick is to hide the externalized costs and get something out there into as many hands as possible such that by the time everyone is hooked on something that the externalized costs get socialized (think of all the financial instruments; think of manufacturing processes involving nasty chemicals, general waste (http://www.storyofstuff.com/). And then there's the cost of having created a lot of people dependent upon technological stuff that they won't be able to operate without it.

Mon, 01/25/2010 - 12:55 | 205346 Seer

Very lucid comments! I agree 100%.

The innovation thing is meaningless without the ability to acquire those new innovations. And right now, and as things continue to turn down, people don't have the money to buy new things. And, anymore the cost of bringing new innovations to market is extremely high, innovations that compel people to go further into debt, is increasing (or more specifically, the affordability is decreasing- less affordable).

Market oversaturation is something that people really have to take into consideration. The "emerging markets" gave a temporary boost, but they cannot carry the day. The biggest market, the US market, is decimated.

Sun, 01/24/2010 - 15:33 | 204647 Anonymous

Well, uhhh, I said a while back , uhhhh, that the game was to herd everyone into Treasuries , UUUhhhhhh, so when the gubernment, uhhhh, DEFAULTS, uhhhh , all the money would be gone. Uhhhh. Also, the whole reason for having all the stocks in the street name 'CEDE & CO' owned by Rome and therefore teh IMF, uhhhh, is so that transfer of ownership can be done smoothly before it's done as is the case right now. You don't own the stock, CEDE & CO (teh IMF) does.

One day they'll close the curtains, raise the houselights and the audience will realize they're trapped inside a cold dank cell with bare cinderblock walls' - Frank Zappa speaking about the american public.

-MobBarley

It's 10pm. DO you know where your FEMA camp is?

Sun, 01/24/2010 - 16:32 | 204702 Seer

Zappa, one of the greats!

Sun, 01/24/2010 - 15:53 | 204669 Anonymous

Gordon, let me explain this in very simple terms so you get it: It is impossible, I repeat, impossible for anyone to predict how this economic crisis will play out for the dollar over the next 10 years. I own Treasuries expiring in 2018 and 2019 as well as massive amounts of gold and silver. If we get deflation, I get a return of and on my money when others who shun Treasuries will not. If we get the inflation that I think will not happen until the interest on our debt exceeds gov't revenues (2020s) than at least I have my gold and silver (lots of it). I'm not trying to be a hero. I'm playing it both ways.

Gordon, what are you doing with your money? You paying out interest on a daily basis to someone on the other side of your short Treasuries trade, while you wait the impending dollar collapse that people have been calling for since the late 1970s?

I actually think you are incredibly dumb for thinking that someone who owns Treasuries and gold/silver is making a mistake in this environment.

Sun, 01/24/2010 - 16:18 | 204689 Anonymous

uh oh, jacking with gekko. when will they ever learn?

Sun, 01/24/2010 - 15:54 | 204670 Anonymous

all this information makes me want to back up the truck and load up on solar stocks.....

Sun, 01/24/2010 - 16:24 | 204694 hooligan2009

as with madoff, the government financing principle is based on always being able to grow debt to repay past debt, with no limit, because there is always some muppet who either prints debt (money) faster than you. There is some kind of mantra that says there has to be increasing capacity funded by leverage (borrowing). This is flawed. If companies make money with a good product, why must they borrow at all? Why not expand based on the expansion in profits, not leverage. Ok, this may be simplistic, but imposing a limit on the degree of leverage of close to zero for a company or a government seems not only reasonable but rational. This leads to another tipping point. Look at Japan. Is there any prospect of Japan ever returning to growth of, say, real of 3% with 2% inflation? Absolutely not! And its easy to see why, this would imply an interest rate of around 5% or two years.Not 0.5%. At 5%, the slow death inflcited on Japan by the tired and past it communists who call themselves politicians, would now mean that an additional 10% of GDP PER ANNUM would get spent on interest and this in itself has a contractionary effect on GDP. Refer back to my "drawdown rate" post earlier, where the people who have used US treasuries as a strore of value, actually want it back at around 5% per annum before they retire. The impact of this drawdown on governments removes any discretion they have to govern, by removing the surplus of taxes over outlays (structural and growing deficits). The current model, implemented by Ben et al, has failed. We either get our heads together and come up with a new one, or we condemn ourselves to a long slide into poverty. I am not sure that there are any resources we have that anyone else wants, aside from our brains and experience. Let's put them to better use and stop this win/lose mentality. The first step might be to forgive all debt, start again and say a big "FU" to everyone else.

Sun, 01/24/2010 - 16:33 | 204703 Anonymous

Tyler,

OT, but why don't you start another blog that reveals to people how you produce and do as much as 20 normal humans combined; I am sure it would be as big a hit as ZH. Seriously.

Sun, 01/24/2010 - 20:58 | 204881 Mad Max

There are multiple people who post under "Tyler Durden." Or perhaps multiple personalities and a lot of Red Bull.

Sun, 01/24/2010 - 16:44 | 204708 Seer

TD wrote: should the US continue on the recent protectionist path, this will implicitly make Chinese demand for Treasuries even scarcer

What is this based on? Further, it's been "protectionist" policies that were the staples of building "successful" bases: that's how the US did it; it's how China IS doing it.

The notion that the US has been operating in a non-protectionist way is absurd. The entire middle east can demonstrate just the opposite! (yes, it's about oil people! oil = energy = non-human slaves; lose this energy and TPTB have to resort to human slaves, many who are currently armed).

The Chinese demand WILL drop no matter what, as they cannot continue with their current growth levels.

Read hooligan2009's comment to have a good real world example of what growth means and how Japan is a perfect example of a stalled country that is heading toward decline. The same will be true of the US. China will win out, though, in the end, no one really wins in a grow-or-die game. NOTE: I don't think that it's wise to say FU to everyone lest we take a huge beating (which we will have deserved); that's how the US would operate with anyone else who were to default against it.

Sun, 01/24/2010 - 16:49 | 204711 hooligan2009

you are right seer, i was assuming a new economic theory would be global

Sun, 01/24/2010 - 16:50 | 204712 Anonymous

Where TF are those furrenors getting the cash to be buying our debt?

If the U.S. can't generate enough margin to buy the U.S. debt, which economy and/or and foreign gummint is legitimately generating enough surplus cash to be investing in U.S. debt?

Right. None exists.

Foreigners are printing their own cash and exchanging it for U.S. debt.

Why this charade continues even five more minutes is beyond comprehension.

Mon, 01/25/2010 - 13:35 | 205408 Seer

Where TF are those furrenors getting the cash to be buying our debt?

There's a reason the US "consumer" was the number one consumer in the world. Goods came in, and money flowed out. To understand how it all works read up on preto-dollar recycling.

The Chinese, and before them the Japanese, were selling a LOT of stuff into US markets. The flood of USD into their countries then had to go somewhere (most often US Treasuries).

So, no, no real printing by other countries, primarily just the US: others can print, but it has a direct and immediate impact on devaluing their currencies.

Sun, 01/24/2010 - 16:59 | 204715 Anonymous

Tyler, where are retail purchases of Treasuries via TreasuryDirect showing up?

Sun, 01/24/2010 - 16:59 | 204716 Instant Karma

How do I buy Australian Bonds?

Sun, 01/24/2010 - 21:00 | 204883 Mad Max

You go to a small shop in a major city and ask for shiny disks with kangaroos stamped on them. Unless, of course, you just want paper.

I would also look at mining stocks (not just gold but of coal and base metal ores as well) as another good way to get some exposure to Australia.

Sun, 01/24/2010 - 17:29 | 204738 hooligan2009

Instant Karma, 3 and ten year govt futures on the SFE, physicals from NAB, CBA, Westac or ANZ, soveregin CDS's from your local hairdresser :)

Sun, 01/24/2010 - 17:43 | 204746 Anonymous

To a repsonse to a earlier post... Yes, I want Financial Armegeddon. I think it's the only viable option left to honestly ever get the market or the country back to any kind of meaningful rebirth.

Currently, the system is broken, has been broken. Only the rich get richer.

Sun, 01/24/2010 - 18:49 | 204789 Mr Lennon Hendrix

Buy silver. The fed is done (yippee!) too bad people have not woken up :( If they had, we could pretend like Knox has gold and backstop the currency (gold to 10,000 in that scenario, but it is going there anyway) Nobody will be buying treasuries in 2 years and nobody will be using doelarrs soon after.

Doelarr to top at 82, if it gets there. then the great HYPE! Gold and silver to the moon.

buy silver.

Sun, 01/24/2010 - 19:00 | 204800 SDRII

From FT

China accuses US of using cyberwarfare People’s Daily issues vitriolic editorial

Sun, 01/24/2010 - 19:50 | 204838 steveo

For aggressive traders, the Chart of Charts called this downturn last Friday. For conservative traders, the 20DMA is still at 2, a neutral range...signaling don't go bear quite yet.

There could be a bounce next week, that would be expected, which is why we should also expect the opposite...a continued plunge. Sunday futures may indicate whether the Pres and his "advisers" still want to pump taxpayer money into the future to ramp them up.

http://oahutrading.blogspot.com/2010/01/charts-of-charts-with-some-expla...

New feature in the Chart of Charts

Green Arrows Mark the 20DMA Crossover.

Trading the 20 DMA is "Safe"--Any drawdowns are minimal and good percentage of trends are captured. I have seen annual returns between 20% and 30% following the 20DMA.

<br><br>Existing Features of Chart of Charts<br><br>Heat Map--A custom indicator that adds "feel" to the root data of number of bearish charts and number of bullish charts.

It uses some back-tested weighting factors that change based on various breakpoints. These were all back-tested to produce highest returns. Red is bear, Blue is bull, Amber is neutral.

Scatter Chart -- Shows the total number of broken out chart counts. Extremely low numbers portend an upcoming big change, similar to low movements in the NYSE McClellan

Oscillator. This chart looks cool, but is not a "Prime Indicator". Perhaps next week I add a moving average to the scatter chart. Maybe an oscillation period will be noticed, and perhaps coordinate with other timing based cycle approaches to stocks.

5, 10, and 20 Day Moving Average DMA. The 5 and 20 DMA are charted. The 20 DMA is near the top, and the 5 DMA is at the bottom. The custom "Toggle Chart" which is at the middle, and composed of thick Blue, Orange and Purple lines depicts CROSSOVERS of the 5,10,20 DMA from bullish to bearish and vice-versa

Link to prior Chart of Charts -- I will say this though, although I was giving EWI a hard time about getting gamed, and they did get gamed and get their stops blown out....they

came back resolutely on the 21st, Thursday, with another call to be highly leveraged short....they got gamed on Monday, but they didn't get scared off.

http://oahutrading.blogspot.com/2010/01/chart-of-charts-without-further....

Sun, 01/24/2010 - 20:18 | 204852 Ned Zeppelin

Why not keep Ben in his chair? It seems to me the policy is what it has to be until further notice: QE2, and regrettably a need to "help" (or at the very least not hinder) the destabilization of other currencies and economies in the rest of the world to force the flight to safety.

Besides, I like the idea of Ben squirming in his chair at hearings. Why let him off the hook?

Sun, 01/24/2010 - 22:11 | 204923 Anonymous

You know, it would be nice if you could link--or at least reference--the Morgan Stanley report from which you've extracted this material.

Speaking for myself only, I'd like to look at the original report.

Mon, 01/25/2010 - 00:56 | 205042 Stevm30

Great article - thank you for this research.

Mon, 01/25/2010 - 01:34 | 205062 Anonymous

Thanks Tyler Durden.

Your blog post may turn out be a great "reality cross-check checklist" post for activity and meetings over the next few months?

In particular, you may have accidentally shortened quite a few meetings coming up in the next couple of weeks?

all the best from

Namke von Federlein

Mon, 01/25/2010 - 03:25 | 205110 joebren

John P Hussman,Ph.D must read column this week

A Blueprint for Financial Reform

http://www.hussmanfunds.com/wmc/wmc100125.htm

Mon, 01/25/2010 - 04:22 | 205119 cthulhu

Oh, my -- Zerohedge got Instalanched.

Mon, 01/25/2010 - 11:43 | 205253 Anonymous

This deflation monster is bigger than anything we have ever seen before. While there will be ups and downs and a few inflation scares along the way, in the end we are going to need qe version 2, 3 ,4 ,5 ,6 and then the reuinion tour of qe and finally a compilation "best of qe" until we are qe'd up to levels no one thought possible. At least you better hope for that outcome. If we are going to maintain our place in the world we need to remember Graham's law and flood the world awith dollars. In a deflationary world whoever creates the liquidity is king.

Mon, 01/25/2010 - 13:06 | 205363 phaesed

Okay, submitted what I found to ZH, basically the data submitted in the Treasury reports should always be in doubt. Honestly, I don't event think they know how to add there. Additionally internal ownership of debt has fallen from the 55 to 60% area to the 23% area over the past 20 years. Basically, between the Fed and Foreign nations, if they call the debt in... we're fucked.

That being said, I couldn't refute the stealth qe thesis, but I did provide more light on the increase of fx reserves.

Mon, 01/25/2010 - 13:31 | 205400 Anonymous

That's bad rap for the rest of the world.

Zhu Min reached the most logical conclusion but sometimes the most logical is not the easiest.

For the present case, this conclusion is straightforward: to buy USD denominated assets, you need USD. You can get USD from the US or get them from someone who got them the US.
And the conclusion reached by Min is an easy one to achieve.
Therefore the US officials have reached it themselves.

Yet they maintain the operation and not for the first time.

Because Zhu Min omits one fact, a lot of impoverished nations have a debt denominated in USD, and they need USD to pay it back. Conveniently, those are countries which are submitted to an extraction economy, meaning they squander their natural resources to sustain other societies than theirs.
As a consequence, other countries have a need for USD in order to buy from these impoverished nations what is needed to support themselves.
Now, they are compelled to maintain a USD reserve.

And this is what the US targets. The US keeps requesting from other countries that they yield their USD reserves to buy US debt. In other words, that they sacrifice their future to support the US.

Fri, 02/25/2011 - 01:00 | 996022 george22