Could the Fed Be Manufacturing Another Crash?

By Graham Summers   Jan 8 2010 9:41AM www.gainspainscapital.com

A week ago, I wrote an essay titled Bonds, Not Stocks, Will be the Big Story in 2010. In it, I detailed how the US Treasury is now facing a debt spiral: a situation where it needs to issue roughly $150 billion of new debt per month WHILE rolling over TRILLIONS in existing debt at a time when investors are willing to lend to it for shorter and shorter periods of time.

Indeed, in the next two months alone, the US must roll over $133 billion in debt.

And this is coming at the precise time that the US will begin issuing roughly $150-300 billion in new debt to finance our $1.5 trillion deficit.

The big question now is… WHO’S going to be buying this stuff?

Historically foreign investors and foreign governments were the biggest buyers of US debt. Indeed, they were the largest in 2009, buying up roughly $700 billion worth of Treasury securities, representing a 23% increase from their purchases of 2008.

On the surface this data makes it look like foreign governments haven’t lost their appetite for US debt… until you look at the data on a month-by-month basis. According to the Treasury Department’s Treasury International Capital Data for October, Foreign Governments have actually become SELLERS of long-term US debt that month. The report notes:

Net foreign acquisition of long-term securities, taking into account adjustments, is estimated to have been $8.3 billion (Graham’s note: we issued nearly $2 TRILLION in debt in 2009).

Foreign holdings of dollar-denominated short-term U.S. securities, including Treasury bills, and other custody liabilities decreased $43.9 billion. Foreign holdings of Treasury bills decreased $38.3 billion.

Thus we see that the annual increase in foreign government purchase of US debt came largely at the BEGINNING or first half of 2009: by October foreign governments were actually SELLING long-term US debt.

Suffice to say, foreign governments likely will not be stepping in to pick up the slack in the Treasury market. The next biggest purchaser of US debt behind Foreign Governments in 2009 was the Federal Reserve itself via its Quantitative Easing Program. Given that unpopularity of this policy it is unlikely to be repeated (at least not in a form large enough to pick up any slack in the Treasury markets).

So what about state or local governments, pension funds, or insurance companies (historically decent sized buyers of US debt)? Eric Sprott of Sprott Asset Management points out that according to Treasury data these groups have either been net sellers or small buyers of Treasury debt in 2009.

The likelihood that these groups suddenly buy hundreds of billions of dollars of Treasuries in 2010 is minimal... the same goes for “other investors” (the third largest group of US debt buyers in 2009, buying nearly $700 billion in US debt and comprised of “Individuals, Government-Sponsored Enterprises (GSE), Brokers and Dealers, Bank Personal Trusts and Estates, Corporate and Non-Corporate Businesses, Individuals and Other Investors).

Unless of course we have ANOTHER Crash in the stock market.

Think about it… The US, if it were treated like a corporation, is effectively bankrupt. And it has to issue a MASSIVE amount of new debt while rolling over TRILLIONS in old debt at the VERY time that most historic buyers of US debt are losing interest in lending to the US for any period longer than a few years.

So how do you create interest?

Simple, let the stock market collapse. The “flight to safety” that would follow would push billions if not hundreds of billions of dollars into Treasuries, soaking up the debt issuance and roll-over with little difficulty.

And why not? Stocks have added $6 trillion to the US household “budget.” Let a third of that slide into Treasuries and you’ve covered the current US deficit for 2010 and S&P 500 would still be at 950 or so.

Please bear in mind, that I am NOT saying the Fed and friends will do this. But given that the Fed is coming under increased scrutiny as public outrage rises, letting stocks come unhinged it perhaps the least politically controversial move the Fed could make (as opposed to another Quantitative Easing Program which would REALLY get the public upset). It would do the following:

1. End the liquidity fueled rally while bringing stocks closer to reality (the higher the rally goes the more painful the subsequent correction will be)
2. Create great demand for Treasuries (something the US desperately NEEDS in 2010)
3. Have relatively minor political ramifications compared to another Quantitative Easing Program or more Bailouts (the public is pissed, Democrats have begun jumping ship, and we ARE in an election year)

Could the Fed be preparing another stock crash to flood the bond market with demand? Who knows? But it would make plenty of sense to me.

Gold certainly seems to be forecasting another round of deflation. In the last month, Gold has staged a serious correction and then a brief bounce. As I write it is right around its 50-DMA.

This is a CRITICAL juncture for the precious metal. If Gold cannot break above this level in a meaningful way, the correction is not over and we will likely be testing the 200-DMA.

Aside from the 50-DMA, Gold also has overhead resistance at $1,140. I wish to add that when the precious metal broke below its upper-trendline said trend-line appears to have become upwards resistance as well:

In plain terms, IF Gold does not break above $1,140 quickly and meaningfully, it is primed for greater losses and we shall be going short. However, IF Gold breaks above these levels, we’ll be going long as it indicates the upward momentum is strong here.

I’m watching this investment closely. As soon as it’s clear what to do, we shall act.

Graham Summers

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