The Treasury Bubble

Bloomberg reports that a soaring U.S. budget deficit will mean billions in bond sales.

With spending on unemployment insurance and other safety- net programs rising, the deficit is already at a record $956.8 billion six months into the fiscal year. To help close that gap, the Treasury Department has more than quadrupled borrowing, pushing the government deeper into debt.

“Tax receipts are just collapsing,” said Chris Ahrens, head of interest-rate strategy at UBS Securities LLC in Stamford, Connecticut, one of 16 primary dealers required to bid at Treasury auctions. The need to sell more debt “is a big issue in the Treasury market and it is ongoing. The surging budget deficit is the primary cause.”

The government will have to sell $2.4 trillion in new bills, notes and bonds in fiscal 2009, according to UBS. From October through December, the Treasury sold a record $569 billion, up from $82 billion in the same period a year earlier, and auctioned another $493 billion in the last quarter, up from $156 billion. That helps to make up for the drop in tax receipts, pay for the rise in spending and refinance maturing debt. Along with the principal, the sales add additional interest costs to the deficit for years to come.

At some point, the Treasury will find it more and more difficult to find enough buyers for all of its debt. This comes at a time when primary treasury dealers are already holding a record amount of treasuries.

The amount of Treasuries held by primary dealers has reached a record as the Federal Reserve buys U.S. debt to combat the recession and bring down consumer borrowing costs.

The bet on higher prices means that if prices fall, the move to bigger yields will be “violent,” according to UBS Securities LLC. UBS is one of the 16 primary dealers that trade directly with the Fed.

[…]

“If this alteration in dealer positions represents a secular change in balance-sheet risk management” it will be another case of unintended consequences, UBS strategists led by William O’Donnell wrote in a note to clients yesterday. “In striving to drive market rates lower, the Fed may have created the conditions for a more violent rise in yields.”

It won't happen any time soon but eventually the economy will start to turn around. Perhaps before then, the existing supply of treasuries will be massive and growing while T-bond holders are running for the exits. How much will the Fed be willing to buy when it sees interest rates cranking up?