Twofish's Blog

December 24, 2008

Elephants in bathtubs – Euro Government Bonds, Treasuries, and GSE’s

Filed under: china, finance — twofish @ 2:52 am

bsetser: It kept spreads on “Agency” MBS high even after the US government effectively guaranteed Agency bonds.

One thing that we learned is that an “effective guarantee” isn’t. Either you guarantee something or you don’t, and Treasury has *NOT* guaranteed Agency bonds.

The US government has agreed to backstop $100 billion in Freddie and Fannie, but that’s all. Also the contract between Treasury and the GSE’s can be revoked if both agree or by an act of Congress which again is nothing like a guarantee.

Also $100 billion isn’t a particularly large amount of money, and it’s hardly inconceivable that Freddie/Fannie will have losses exceeding that. AIG has already burned through $150 billion, and each GSE has a portfolio of about $2 trillion which makes it trivial to have $100 billion in losses if things go bad.


Also, I question whether the US Treasury market is large enough by itself to absorb Chinese and Saudi reserve holdings without causing massive market disruption.

Before July, agency bonds were acting as a proxy for Treasuries adding about $5 trillion to the volume of bonds available to hold reserves. Once central banks stopped buying agencies and shifted to Treasuries, we’ve had massive market disruption in the form of negative interest on T-bills and huge spreads on everything else. It’s like watching an elephant in a bathtub when the bathtub suddenly got smaller.

Given what’s happened with the shift from agencies to treasuries, seeing more than a 20% shift in PBC holding from Treasuries to Euro-bonds seems to me impractical without a lot of market disruption, which is the last thing that anyone wants right now.

I strongly think that with Treasury rates negative and Obama talking about massive stimulus packages and trillion dollar deficits, that we’ll end up in 2009 with the world economy more “unbalanced” than in 2008.


Also for the system to break in really big way, China doesn’t have to buy every single Euro-government bond out there, all it has to do is to buy enough so that the yield on those bond starts hitting zero. Once you have Euro-government bonds with zero interest, you can no longer do monetary policy so at that point the only way you can control the economy is through fiscal policy. If you have a system such as in Europe, where the fiscal policies are fixed, then it becomes impossible to do any sort of macro-economic policy at all.

Something similar is happening right now with the United States and the fact that no one is buying agencies anymore. If everyone buys Treasuries, the US can’t do monetary policy anymore, and so the only thing left is fiscal policy.

I’m sure that there are ways of restructuring the system to deal with this issue, just as the US fiscal and monetary system is being massively restructured right now. It seems inevitable to me that the Fed is going into the home mortgage business whether it wants to or not.

However, it will involve quite a bit of coordination, and the PBC can’t say one day “let’s switch to Euros” without a huge amount of disruption which I can’t see them wanting.

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