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Guest Post: There Will Never Be A Failed US Treasury Auction... Until There Is

Tyler Durden's picture




 

From Brian Rogers

There Will Never Be A Failed US Treasury Auction... Until There Is

 

"The antidote to hubris, to overweening pride, is irony, that capacity to discover and systematize ideas.  Or, as Emerson insisted, the development of consciousness, consciousness, consciousness." 

-Ralph Ellison

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

 

Asymmetric Trades

One thing I've learned from my 14 years of working on Wall Street is that no matter how much you think you know, no matter how certain you are of something or how well you know how to "play the game," reality inevitably comes along and shows you just how ignorant you were, are and probably always will be.

It can be a very humbling business no matter who you are.  And if you're in it long enough and doing anything of any relevance whatsoever, you too will one day eat a big heaping helping of humble pie.

Just look at some of the modern investing "legends" or "masters of the universe" littering the side of the road with sub-index returns and below high-water mark funds.

But one thing to look for that can and often does lead to outsized returns is when everyone in the market is "certain" of something.  This is when risk/return profiles can get really interesting because the payoff starts to get asymmetric.  Kyle Bass talks about this kind of payoff in the trades he looks for.

Regardless if you agree or disagree with the thing that everyone is "certain" of, if you can spot an argument like this where nearly everyone has piled on to one side of the boat, you should do some homework because this is usually precisely the thing that can cause assets and even entire markets to make big moves.

A good example of this is the recent collapse of the US housing market and the associated collapse of mortgage-related securities.

"We've never had a decline in house prices on a nationwide basis."

As a former mortgage and CDO salesman at a TBTF (forgive me Father, for I have sinned), I had a front row seat to watch not only what was happening in the industry but also the overwhelmingly prevalent attitude that investors had about the asset class at the time.

The Bernank summed things up nicely in July, 2005 when he said, "We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though."

Now I love to give our monetary fiat ponzi central planner in chief as much grief as the next critical thinking monkey, but his statement above absolutely reflected the prevailing attitude of almost every major market participant at the time.  Yours truly included.

To be fair, not everyone shared this view.  I sat a few dozen feet away from Greg Lippmann in late 2005 and still kick myself for not grabbing one of the t-shirts he had printed up sitting in a box near his desk that said simply, "I'm short your house."

But aside from Greg and a few other out-of-consensus thinkers, nearly everyone and their brother agreed with the Bernank.  Strongly agreed.  And here was your asymmetric opportunity.  Everybody believing thast something simply cannot happen or will continue to happen in a particular way.  Has never happened, will not happen, will not change.  Next question.

Of course, if it does happen, things will got to hell in a handbasket, but don't you worry your pretty little head about that, it will not happen.  Everyone says so. 

This allowed nearly the entire financial world to be as calm as Hindu cows while watching underwriting standards for mortgages collapse to an almost  meaningless level.  Before the party ended, most of the major mortgage underwriters got comfortable with >100% LTV second liens by thinking of them as "bridge loans" meaning house prices were rising so surely and regularly, they believed the second lien would be paid off by the increase in the underlying property value when the owner flipped the place for a nice profit.  Uhh, yea. 

Authors note: for those curious, the answer is no, I did not predict the collapse of housing despite my place at the table.  Like most others around me, I had been drinking giant gulps of Kool-Aid.  I have since gone on a massive Kool-Aid 12-step program.  In fact, realizing how economically and politically naïve I was has been one of the critical turning points in my life.  Recognizing, acknowledging and dealing with my own cognitive dissonance has been nothing short of a journey towards personal enlightment.  I wonder if the Bernank could ever admit to something like this?  I highly doubt it, even though we'd all be better off if he did.  Personally, I think the Bernank's marquee spot in the Havenstein Museum of Failed Central Bankers is all but guaranteed at this point.  But I digress...

Regardless of your view on housing or knowledege of mortgage securities, if you had recognized that everyone was sitting on one side of the boat, you would have found the trade of the 00s.

Which brings me to the US Treasury market.

US Treasury Market Exceptionalism

Paul McCulley and Zoltan Pozsar presented a paper at the Banque of France on March 26 where they address "critical questions which are not currently being addressed by policymakers."  The FT reported on this a few days ago (link here).

Having worked with Paul McCulley for a few years in the early 00s, I can say without reservation that he is one of the smartest, nicest, funniest, most genuine people I have ever met.  Not just in the markets, but in life in general.  Despite the fact that I rarely agree with his economic views, Paul is, quite simply said, a great guy and true gentleman.

However, nice guy accolades aside, McCulley expresses a view in his paper that completely sums up the key assumption on which the entire global financial fiat ponzi system hinges.  Namely, the casual assumption that there will never be a failed US Treasury auction or even reason to fear rising US rates.

McCulley and Pozsar express the following view when attempting to dismiss hand-wringing over rising US Treasury rates or a failed US Treasury auction:

"Crowding out, overheating and rising interest rates are also not likely to be a problem as there is no competition for funds from the private sector. For evidence, look no further than the impact of government borrowing on long-term interest rates in the U.S. during the Great Depression, or more recently, Japan. A buyers’ strike is also unlikely, especially in the case of the U.S. This is because countries with mercantilist policies tied to the U.S. dollar are de facto piggybacking on the U.S.’s internal demand, and simply have no option but to continue to accumulate U.S. Treasuries to moderate the real appreciation of their exchange rates so as to hold their shares of U.S. demand."

I'm not going to go into a big discussion here about Modern Monetary Theory, the Great Depression or Japan.  For starters, that's not the theme of this article but more to the point, I have no clue what's going to happen next regarding interest rates in the US or any other country.  Despite what information may or may not be gleaned from previous events, we are absolutely in unchartered territory from an economic and geo-political perspective.  In other words, no one really knows what's going to happen next.

And that's exactly the point.  Neither I nor any other person on the face of the planet knows exactly what's going to happen to interest rates in the next 2 seconds, let alone 2 months or 2 years.  So much is happening and changing at such a rapid pace, thinking that anything will "never" or "always" happen strikes me as pure, unadulterated hubris.  The madness of crowds.

And yet, everything in modern finance hinges on the assumption that US rates will remain low and buyers plentiful enough to dilute and mask the Fed's own forced buying.  Essentially, the entire market is betting that the Fed will always and forever be able to manipulate Treasury rates and ensure successful Treasury auctions.  Jim Quinn talked about this in one of his latest posts, "You Ain't Seen Nothing Yet - Part 3" (link here).

TPTB are absolutely all-in on this concept.  It underlines the "confidence" the Bernank always talks about.  It ensures the current political-economy (credit to Martin Armstrong for that phrase) lives another day and our current crop of bought-and-paid-for politicians can keep feeding at the government trough. 

Sound a bit asymmetric?  You bet it does.

Will Atlas Shrug?

Think about that. 

Do you think the US will always and forever be able to pay for our over-bloated military-industrial complex and our wars of choice? 

Do you think the federal housing agencies will always and forever be able to subsidize the real estate industry with money losing, non-economic mortgage loans?

Do you think the government will always and forever be able to pay on the promises they've made regarding Social Security, Medicare and Medicade?

Do you think the government will always and forever be able to extend debt-enslaving, subsidized student loans to anyone with a pulse?

Do you think the fiat ponzi central planners at the Fed will always and forever be able to manipulate the Treasury curve to whatever levels the Oracles of Delphi decide?

If you answer yes to the above, ask yourself this: how would all of these things be affected if the average interest rate paid by the US was to rise to 5%?  At today's debt level of $15.6 trillion, the interest expense would be approximately $780 billion or about 35% of total government revenues.  Welcome to the United States of Greece.  Next stop, bankruptcy.

Housing will collapse as mortgage rates approach 8%.  Every aspect of federal, state and local government spending will have to be slashed.  Police, fire, schools, medical services, mail delivery, trash delivery, road maintenance and every other kind of social service will be cut dramatically as capital is diverted to pay interest on our debt.

And these sudden rate rises can happen brutally fast in our uber-connected global ponzi.  Just ask Italy.  4% rates and it was bunga bunga time.  Rates jump to 7% a few months later and suddenly the Vampire Squid has to send in one of their own to "save" the day.  You get the idea.

I think it's no exaggeration at all to say that keeping US rates low, ZIRP low, for the foreseeable future (ie, forever) is key to maintaining the semblance of stability in the current global fiat ponzi.  Nearly every major financial player on the planet is counting on this being an a priori piece of knowledge.

And there's your trade.  Everyone is betting on this one idea -  that the Fed will never lose control of interest rates and the US Treasury will never have a failed auction.  The same way nearly every major financial player on the planet was willing to bet that US real estate could never fall for an extended period of time. 

And we all know how that trade worked out.

Timing, please?

Of course, the big question for most Zero Hege readers is not if this will happen, but when. 

Who knows?  Not me.  Not Paul McCulley.  Not the Bernank.  Not Timmy G.  Not any financial pundit or TBTF economist.  No one knows.

These abnormal, asymmetric situations have a tendency to go on longer than anyone suspects. 

I recall hearing in 2009 that legendary hedge fund investor Julian Robertson was making a big bet on a Treasury steepener trade (essentially a bet that longer-term interest rates will rise more than short-term rates).  I completely agreed with him.  And at least in the short run, we have both been more or less wrong.  Again, this business can be humbling.

But eventually, just like the guys who bet against housing in 2005, 2006 and 2007, eventually I think Mr. Robertson will be proven right.  Big time right.

And TPTB, the Bernank, TBTF, market consensus and everyone long 30-year Treasuries, wrong.  Completely wrong.

There will never be a failed US Treasury auction.  Until there is.

 

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Sat, 04/07/2012 - 17:39 | 2325059 ekm
ekm's picture

I've noticed one strange thing about PIMCO:

They are ALWAYS WRONG about what they say, but....they ALWAYS MAKE MONEY.

Isn't that a bitch?

Sat, 04/07/2012 - 17:46 | 2325064 InvertedQuotes
InvertedQuotes's picture

All good things must come to an end, but lest we not forget that the numbers no longer matter in a technology-driven modern world.  The sheeple can no longer group up out of frustration and anger and throw a fit against the establishment. Their numbers mean nothing against the technology that the government controls.

So live on, continue to spend your money on drinks, girls, and hot rides.

http://www.elitechicagolimo.com

Sat, 04/07/2012 - 18:21 | 2325123 CryingBear
CryingBear's picture

treasuries are going to 0% as soon as the EZ blows up and money flows to USTs while dumbasses are short

Sat, 04/07/2012 - 18:27 | 2325134 seek
seek's picture

I actually don't think we'll ever get to the point of a failed auction.

Right before that point will be reached, they'll stop having them. Presumably right before this point is when the USD fails completely, which will happen sometime after the great USD devaluation (and auctions will continue after that event!)

Sat, 04/07/2012 - 19:15 | 2325215 Federal Reserf
Federal Reserf's picture

Today while driving about, some Investment adviser on the radio opined that too many investors are steered towards high risk. He suggested that more of us should buy UST since they are safe because they can always print USD to pay for redemptions. Sounds good to me since I can always count on getting my dollars back with interest.

Sat, 04/07/2012 - 19:18 | 2325218 Sechel
Sechel's picture

Since the U.S. borrows in it's own currency, the idea that an auction fails is ludicrous. The interest rate as the MMT'ers will state is only an inflation control  mechanism to sop up too many dollars floating around.  That the FOMC speaks to it's primary dealers and vice versa means that everyone knows in advance the rates required. No auction can fail.

Sat, 04/07/2012 - 20:07 | 2325275 Quinvarius
Quinvarius's picture

Yeah.  The Treasury market is not a market.  It is the transmission method of printed credit from the Fed to the US government.  The black swan in the Treasury market is that there isn't a Treasury market.  As much as I hate to say it, it is counterproductive to the new Treasury paradigm for them to pay interest at all.  For their new purpose of free government life support/de facto printing press, negative interest rates are more rational.  The author is still in th box.  You don't go short this mess by shorting Treasuries.  You do it by going long gold, or some other real asset if you think it will perfrom better than hard money.

Sun, 04/08/2012 - 09:00 | 2325959 HurricaneSeason
HurricaneSeason's picture

The U.S. doesn't borrow in it's own currency, it borrows in Feral Reserve Notes. The Feral Reserve has let the U.S. borrow trillions that the Feral Reserve never had and backstopped or guaranteed more in MBS. The Feral Reserve won't want to loan the U.S. 10 or 20 trillion dollars. They'll want to cap it at $5 trillion or so in bonds, because they never had the $5 trillion to lend.

Sat, 04/07/2012 - 20:03 | 2325274 ekm
ekm's picture

http://www.nytimes.com/2012/04/08/world/middleeast/us-defines-its-demands-for-new-round-of-talks-with-iran.html?hp

If there is something that actually guarantees demand for UST, is what the article is talking about.

Every president must wage war in order to be taken seriously. Carter didn't and ...........................

Sat, 04/07/2012 - 20:15 | 2325284 Quinvarius
Quinvarius's picture

Blink.

Sat, 04/07/2012 - 20:23 | 2325293 GCT
GCT's picture

The newest government scheme was announced today all.  The HUD secretary wants everyone to write down homes (especially fannie and freddie imagine that) to their current value and refinance.  But of course you have to be in foreclosure or underwater on your home.  I guess if you work for a living, paid off or pay your mortgage on time, save money and invest wisely and do not got out and try to keep up with the Jones your stupid these days.  I am getting so frustrated when success equate to being greedy or your not sacrificing enough for the masses.

Time for a drink for a change!  But then when you spell HUD backward you get DUH!

Sat, 04/07/2012 - 21:07 | 2325333 mind_imminst
mind_imminst's picture

If no one else will say it, I will: THERE WILL NEVER BE A FAILED US TREASURY AUCTION!!!

 

The FED will buy 100% of the paper in a bidless market, all day. EVERY DAY!!

 

Now let us qualify with some knock-on effects. The fact that the FED prints trillions of dollars and buys UST in a bidless market, does not mean everything is ok. This action will have catastrophic effects in other debt and securities markets. Inflation could go sky high. Draconian regulations regarding gold, cash, and commodities might have to be put into place. Bank holidays and all that. It won't be pretty when the FED buys every scrap of UST crap, but they will buy, until the whole ponzi comes crashing down. So in a way, when the FED has to step in with trillions of digital fiats to prevent failed auction after failed auction, it is near a tipping point for fiat/ponzi economies, so it will eventually lead to a "failure" of the system as a whole (including the FED), but by the literal traditional meaing of "a failed UST auction". IT WILL NEVER HAPPEN

Sat, 04/07/2012 - 21:20 | 2325350 ekm
ekm's picture

Scenario:

Treasury issues too much debt. Nobody wants to buy it but the Primary Dealers/Fed. Hence, nobody is giving real goods in exchange for electrons (electronic dollars). Same as, for example Cuba issuing treasuries and the Cuban central bank buying them, but nobody gives a fuck.

Conclusion:

If and when it happens, the auction will since all Primary Dealers would go bankrupt or refuse to buy them.

Currently:

A lot of electronic dollars were printed, used for USTs, and the Primary Dealers placed the electrons back to the Fed. It didn't touch the people, it was not exchanged with real goods and services. Something tells me the resource producers of the world did not accept to give real stuff in exchange for electrons.

Sat, 04/07/2012 - 23:16 | 2325476 bshirley1968
bshirley1968's picture

You are exactly correct and we are close to that now.   The Fed knows they are red-lining right now with all the printing that has gone on and that is why they are acting as if they are not going to print anymore right now.  I give them 6 months at the most before they have to start up again and Europe may force their hand before then.  I would say we are 60% there right now.  They can say the Fed is not monetizing the debt "directly" and that may be the case, but indirectly they are funding a bunch of institutions to directly buy the debt.  The rest of the world is getting tired of buying this depreciating asset that comes with risk and they are getting tired of paying higher prices so we can all live like kings in the US.  When we reach the 80% mark, it is game over.  We will quickly jump to the 100% mark from there. 

Sat, 04/07/2012 - 21:28 | 2325366 mind_imminst
mind_imminst's picture

Currently:

 

The US government puts those electrons (they get from the FED) into the accounts of everyone who works for or does business with it (US.gov). The masses might stop accepting fiats and electrons from the US government (and bring the whole system down) but that is semantically and functionally different than a failed UST auction.

Sat, 04/07/2012 - 22:05 | 2325391 ekm
ekm's picture

Ok, makes sense. I am not trying to prove myself or you right or wrong. I'm trying to find out whether it can actually happen or not. Don't care if I get proven wrong.

Question: Is there a chance that few of the Primary Dealers refuse to buy UST? Or all PDs refuse to.

Would the auction fail?

Note that Wells Fargo refused to become a PD regardless of offers to become one.

Sun, 04/08/2012 - 06:59 | 2325855 mind_imminst
mind_imminst's picture

Yes, and I am trying to be provocative.;) You could be right. There might be an issue I am over-looking. PDs might revolt.

Sat, 04/07/2012 - 22:23 | 2325428 Steyr
Steyr's picture

"Do you think the US will always and forever be able to pay for our over-bloated military-industrial complex and our wars of choice? "

 

Over-bloated mil-industrial complex? 

Puleeze, sir.  If you think that's the biggest problem in this nation's spending, then I'd suggest you're probably a leftist unwilling to make meaningful cuts in the ENTITLEMENT segment of the federal budget.

Sat, 04/07/2012 - 23:08 | 2325467 bshirley1968
bshirley1968's picture

You need to wake up, "sir", if you believe that the "Defense Budget" is all that is spent by this country to maintain the empire around the world.  Maybe you need to reel in your rightwing leanings just a bit.  And remember most of that money spent has nothing to do with our "defense" but rather the insured dominance of the dollar.

Sat, 04/07/2012 - 23:10 | 2325469 SilverSavant
SilverSavant's picture

Isn't it ironic, that so many ZH readers cannot recognize irony?    They must think they are too smart to be fooled.    Case in point-- VtheMAXILOPEZpsycho

Sun, 04/08/2012 - 02:23 | 2325686 reTARD
reTARD's picture

... and I'm Captain Obvious.

Sun, 04/08/2012 - 03:11 | 2325725 lemonobrien
lemonobrien's picture

i think QE == failed treasury auction; otherwise, they wouldn't need it.

Sun, 04/08/2012 - 09:32 | 2325998 monopoly
monopoly's picture

We have said it here time an time again. Until the printing press is taken away from the inmates, nothing, nothing will change. And at some point interest rates will rise, and continue to rise. Then the head inmate at the asylum will finally be put in a straight jacket, with a noose around his neck daring him to try and print. 

Interest rates will continue higher and we will be "forced", forced to stop spending and cut everything, entitlements, our absurd and bloated defense budget, all govt. spending, including the insolvent Post OFfice, the moronic salaries, benefits and retirement of our bloated idiotic Congress, and education. Why is it that so few of us see the writing on the wall. It cannot continue and we will not "grow" out of our debt. We will be over 16T in debt before the election. Why is it that so few understand the path we are on? We are now in the eye of the hurricane, which will soon pass over us and then the full force of a Category 5 hurricane will be upon us. 

Gold at these prices and maybe a little lower? What a gift all. If you can, take advantage of it. Or do you want to keep dollars? If you have some assets that you can move, how can you NOT own physical gold and silver. How can you NOT!

Sun, 04/08/2012 - 11:32 | 2326136 MGA_1
MGA_1's picture

Print baby, print !

Sun, 04/08/2012 - 19:05 | 2326753 Pepromene
Pepromene's picture

The CD comsuming public has been beliveing the Fed when there are told that rates are low because inflation is low.  The real truth is the government cannot afford to allow interest rates to rise because the ensuing payback just might push us over the edge.

Mon, 04/09/2012 - 01:03 | 2327285 JeffB
JeffB's picture

As I understand it, the Fed is already a big buyer.

It also seems to me that there is no legal limit to how much they can purchase. It really boils down to how much they can purchase when inflation rears its ugly head.

In other words, whether we have a failed auction is pretty much a choice the Fed will have to make. At some point I imagine they'll be forced to choose between roaring inflation or outright bankruptcy.

 

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