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Wednesday, January 07, 2004

All the Way Up the Yield Curve

Actually, I just realised there is one small flaw in my Bernanke post of yesterday: the US Federal Reserve dosn't need to buy the government debt, well not yet anyway. The reason why: the foreign central banks are doing it:

Treasuries edged higher on Wednesday on news that the Treasury's five-year note auction, the first major auction of U.S. government debt this year, attracted strong demand, including from foreign central banks.

Indirect bidders, which mainly comprise foreign central banks, picked up 40 percent of the issue, beating last month's 34.6 percent. The sale of $16 billion in new five-year Treasury notes went at a yield of 3.26 percent and drew bids for a hefty 2.50 times the amount on offer, way above the 2.09 average of last year's sales.........

Dealers believe offshore central banks account for much of the indirect bidding as they spend some of the dollars they have been amassing in recent days. The Bank of Japan was thought to have bought an astonishing $28 billion in just the first two days of this week in an attempt to support the yen. Much of this money is thought to end up in Treasuries, an understandable assumption given that foreign central bank holdings of Treasury and agency debt ballooned by $224 billion last year to a record $1.07 trillion, and by $91 billion last quarter alone.

Alan Ruskin, chief economist at 4CAST, noted that is equivalent to financing 79 percent of the Treasury's entire net borrowing needs in the fourth quarter. "No wonder the Treasury market is so resilient to the influx of exceptionally strong data and the scale of supply," Ruskin said. He said central banks like the BOJ were doing the Federal Reserve (news - web sites), and the White House for that matter, a big favor by holding Treasury yields down. "Two hundred billion dollar Treasury purchases from the Fed would have been widely viewed as a massive distortion. But foreign central banks doing exactly the same thing is quietly sanctioned and encouraged by U.S. policy-makers," he added.
Source: Yahoo News

Ok, so this is a twist that really needs a bit more thought. Let's just imagine that all the central banks end up buying each others treasury debt, what is the consequence? Well clearly if they are printing money to do this - obviously if they are not then the thing probably ends up being pretty neutral until someone wants to collect on the debt from one of the indebted governments, they would in this case be only swapping bits of paper - so if they are printing money, then they are collectively undermining the unit value of each of their currencies, ie producing inflation. But then if there is a global deflationary backdraft, that inflation may simply mean that the CPI's simply register zero instead of minus 3 say. So on one front nothing changes.

But of course on another something definitely does. For what the central banks would be doing would be collectively financing each others government debts, that is the money would be channeled to the public, and not the private sector, hence there would be an effective redistribution towards public, and away from private consumption. That is one thing to think about.

Another topic might be the case of a country like China where the purchase of treasuries may only reflect an inward dollar flow, purchasing yuan to speculate on a future revaluation. Then clearly at some stage the yuan will revalue, and the Chinese central bank will simply take a loss on all the non-yuan assets it holds. The Chinese will end up being collectively richer, and everyone else poorer by the extent of the revaluation. But wait a minute, seeing the yuan rising, what if the central banks start buying Chinese government debt, as something more solid, and backed by an appreciating currency (I mean they should be neutral about location these central banks, simply following the law of best price): then clearly to attract finance the other governments will have to raise yields - here is where the problem may lie, and ultimately come. Remember Argentina had both deflation and massive risk premiums. Well, that's it. This was just thinking aloud really. Interesting set of problems though, aren't they? (In fairness I would like to point out that Lloyd was more or less covering this story on his blog about three weeks ago).

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