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 [24]).
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 [24]).
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.