Yesterday we had the start of the US Treasury auctions for the week and there was a captivating development. Given the concerns over Pimco Gross comments that the US could lose its AAA rating, one would've expected this auction to have weak foreign demand. It was the opposite. The 2y US Tsy note had a rate of 0.940% with 2.94 coverage that was better than expected. However, the indirects (foreign buyers) were $21.475 bln or 54.4% vs almost 29% in Apr against a long-term avg of 35%. Clearly, carry is back with a vengeance in the Treasury markets. The thinking is buy the 2yr note for .94% yield and fund it with O/N cost of .25%.
This strategy is predicated upon the concept that the Federal Reserve will not raise rates for a long period of time, perhaps even 2 years. Today, theNational Association of Business Economists or NABEput out their predictions for Fed policy. Members believe that the Federal Reserve is likely to leave the federal funds rate in a 0% to 0.25% until next spring, then raise it to 1.25% by the end of 2010. They see signs the economy is "stabilizing" and expect the gross domestic product to grow in the second half, but they expect recovery to be only gradual and marked by continued labor market deterioration according to MNI. This gives the above mentioned strategy at least one year of working before the risk from the Fed raising rates kicks in.
However, the demand for US 2 yr has more than just carry going on with it. There is a serious duration play as the market grows increasingly nervous over the massive supply of US debt. This is what I wrote about yesterday, but there are others with better pedigrees with similar views. The FT today carries commentary by former US Treasury Undersecretary for International John Taylor stating that Standard and Poor’s decision to downgrade its outlook for British sovereign debt from “stable” to “negative” should be a wake-up call for the US Congress and administration.
"Under President Barack Obama’s budget plan, the federal debt is exploding. To be precise, it is rising – and will continue to rise – much faster than gross domestic product, a measure of America’s ability to service it. The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years."
As I wrote yesterday , the last time this occurred was during during World War II. To be doing this today, is an financial experiment that has never been attempted on this scale before and is a leap of faith that centers around the reputation of the United States to pay its bills. Given the penchant for Congress to spend without thinking, the bond markets will be voting a lot sooner than the American electorate.
Eventually, it'll be a "throw-the-bums-out" result.