The Mystery of the US Treasury Market


The US Treasury market continues to baffle.

Despite an almost unfathomable supply of U.S. government debt, yields right across the curve remain at stunningly low levels. It almost seems as if the law of supply and demand has been suspended.

The quest to explain this phenomenon is giving rise to a conspiracy theory of the markets: the Fed is secretly propping up demand for Treasurys by printing dollars.

Over at, Jeff Nielsen, of an outfit called Silver Gold Bull (“America’s fastest-growing bullions company”), explains this idea:

Much like the proverbial "lead zeppelin" defies the laws of physics, the current status of the Treasury market defies all of our financial fundamentals. It is a market that cannot exist, and yet it does.

Previously, my own writing has focused upon one particular aspect of this absurdity: the highest prices for U.S. Treasuries at a time of maximum supply. This, in itself, is an absolute financial contradiction. The highest supply in history directly implies the lowest prices in history, for every market in the world — except U.S. Treasuries.

But that is merely Act One of this Theater of the Absurd. These maximum prices are occurring at the point in history where the U.S. has never been less solvent. This also directly implies that U.S. Treasuries should be fetching the lowest prices in history — as is occurring with their deadbeat counterparts in Europe.

No one has been able to explain this ultimate financial contradiction, and so I have previously done so myself. My solution for this conundrum was based upon the Holmesian Principle of logic asserted by Sir Arthur Conan Doyle: When you eliminate the impossible, whatever remains (no matter how unlikely) must be the answer.

In applying this principle to the logical/financial contradiction of the U.S. Treasury market, I was left with only one possibility: that B.S. Bernanke is secretly (and illegally) counterfeiting U.S. dollars — and using those bogus dollars to prop up the U.S. Treasury market.

Joe Weisenthal did a great job Tuesday morning shooting down this idea. As the chart below shows, Treasury yields (represented by the rising red line) have been falling for 30 years, even as the national debt has been rising.

As Weisenthal explains, this isn’t really all that mysterious. Government debt emerges from deficit spending: that is when the government is spending more into the economy than it subtracts in taxes. When deficits and debt issuance rise, it means the amount of additional dollars the government is putting out into the economy is rising. This spending is an important source of the demand for Treasury bonds. So rising demand for Treasurys along side rising supply—which implies rising deficit spending—is not a “contradiction” at all.

But there’s another part of the demand for Treasury bonds that should be addressed. Analyzing the demand for Treasurys without taking in the broader context of financial markets and economic circumstances is always a mistake. Investors in U.S. Treasury bonds certainly do not make this mistake as often as market pundits do.

Imagine, for a moment, that U.S. wine makers have a boom production year that drives up the volume of U.S. wine available in markets. Now imagine that prices on bottles of U.S. wine rise with the increased volume.

This might be evidence of a price-fixing conspiracy. But if you discovered that, say, French, Italian and South American wine crops had suffered a horrible shortfall fall that same year, you’d probably conclude that it wasn’t price-fixing. The law of supply and demand still applied—so long as you consider the broader market context.

Something like this is exactly what has happened in the market for safe financial assets. Beginning in 2007, the world’s stock of outstanding “safe” financial assets—those subject to minimal default risk—has been declining rapidly.

This chart, which comes from Credit Suisse’s 2012 Global Report and was brought to my attention by FT Alphaville’s Cardiff Garcia, illustrates the impressive contraction of safe assets available to investors.

It goes without saying that this decline has not been driven by a lack of demand for safe assets. In fact, the demand for safe assets most likely remains close to its long-term, post-war historical trend of about one-third of all assets.

Viewed in this light, there is no contradiction or mystery at all to falling Treasury yields. Investors are buying the stock of safe assets even faster than the world can produce them. The evidence of negative real rates on some issuances of German bonds, for example, points toward a shortage of safe-assets.

This is an area where fiscal and monetary policy tend to blend in confusing ways. Because safe-assets perform money like functions for financial institutions and sophisticated investors—supplying collateral for trades, being highly liquid and very safe—contractions of safe assets act much like monetary contractions. A reduction in deficit spending (or, more specifically, a reduction in the issuance of bonds that accompany deficit spending), in other words, is a reduction in the outstanding pseudo-monetary supply for the global economy.

Getting this right is important for understanding fiscal and monetary policy. We’re living through a great contraction of safe assets, which puts enormous strain on a financial system heavily reliant on collateralized trading between counter-parties. Any program that threatens to reduce, say, the amount of debt issued by the U.S. government should at least take into consideration the likely effects of further contraction.

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