Deepish Thought

Today’s 30-year treasury bond auction apparently went smoothly, with prices even firming slightly in subsequent trading.   I confess that I don’t fully understand why there is such strong investor demand for long term (and thus inflation sensitive) treasury debt.  Some of the possible  explanations are:

1. The bond market is deeply pessimistic about the economy, meaning that deflation is a possible concern and holding 30 year government bonds with a 4.5% yield is actually quite attractive.
2. The bond market is very optimistic (snicker) about both the Fed’s ability to shrink its balance sheet  and government’s ability to bring the fiscal deficit under control when the economy improves, meaning that inflation is not a threat.
3. Global imbalances  have become, to an extent, self perpetuating.

The third explanation arises from an old, informal rule of banking, “If you owe a $100 the bank owns you.  If you owe a $100m you own the bank”.  My thinking here is that the United States has become a debtor that is too important to be denied credit.

Due to years of conscientious currency manipulation China (and other trade surplus nations) have accumulated enormous dollar assets.  Protecting the value of these assets is not an insignificant concern.  This means that US interest rates cannot be allowed to go up in any situation where the rise would not be accompanied by an offsetting rise in the dollar.

The 30 year bond auction was just such a situation.  A poor auction would have resulted in higher long term interest rates.  Normally higher rates would put upward pressure on the dollar.  However, right now, a bad auction would imply that the government is going to have difficulty funding the deficit, increasing the likelihood that the deficit will be monetized, which would be bad for the dollar.

So a bad auction would likely mean US interest rates up and the US dollar down, which is the worst possible combination if you happen to be a foreign power that owns a lot of dollar assets.

If you were such a power my guess is that ensuring a strong auction, by say bidding for a bunch of bonds, would start to look like a good idea.  Interestingly, indirect bidding (i.e. by foreign central banks) during the Treasury auction was described as “strong”.