Saturday, 7 May 2011

US Bond Markets, and the Novelty of Saving

The truth is, the US financial community isn't used to their economy running a private sector savings surplus - which is hardly surprising because until the financial crisis came along, it hadn't run one since the early 1990s. One result is that there are plenty of people in the US financial industry who don't instinctively understand the link between that surplus and cashflow/balance sheet movements in the banking industry.

Two strands of recent popular economic contention illustrate the point. First, when the Fed stops hoovering up government debt (sometime in June), will that result in a major bond correction? Second, now surveys show US loan conditions beginning finally to ease, are we about to see banks forced into selling off their bloated portfolio of government securities in order to fund new private sector credit?

Behind both worries lurks the same (probably unanswerable) question: why is US government debt trading above its fair value, with 10yr bonds changing hands at around 3.2%, rather than nearer the 4% that underlying conditions (policy rates, inflation, growth) would imply?  Will either of these two near-term worries upset the apple-cart.

Once again, I turn to the US private sector savings surplus.

The key point about the private sector running a savings surplus is that it represents the direction of cashflow between the US private economy and the financial system. If there is a surplus, then the financial system, after it's done all the lending and investing it can with the private sector, remains a net receiver of cash, day in, day out. And since by definition it can't deploy that cash in new private sector lending, it must necessarily end up buying either government debt or foreign assets.  When there is a deficit, by contrast, the financial system faces an urgent need to generate the cash it needs to give to a private sector which otherwise would have to make its own adjustments. And what are the two main ways for banks to raise cash? Liquidate its government bond position and/or take on net foreign liabilities. 

So when we look at the emergence of a private sector savings surplus in the US since mid-2008, we can understand why  holdings of securities have jumped by just under half a trillion dollars, and why, at the same time, net foreign liabilities of the banking system have shrunk by just under US$700 billion. What else could possibly have been expected?

Whilst the private sector continues to run a savings surplus, these flows will - must - continue, regardless of the curtailment of the Fed's buying, and/or the improvement of credit conditions.

For those worrying about the fair value of US government bonds, then, the question should be: how long will the US private sector continue to throw off surplus savings.  There are two techniques for determining this. The first is to model the numbers line by line. So far as I can tell, no-one on the Street is doing that (and neither am I, before you ask). The second is to eyeball the trend. This gives you two alternative answers. First, if the steep decline seen in 1Q is maintained (which, I suspect, can be translated as 'if oil prices continue to rise') then the US will get through its surplus by mid-2012.  If, on the other hand, the more modest trajectory of normalization seen over the last two years is extended, the surplus will endure until around mid-2013.  My guess? Even by mid-2013 the US will still be running a savings surplus, and the rest of the economy will adjust around that fundamental choice. Quite simply, it's what defines the 'New Normal'.

Luckily, by that time, less unorthodox economists than myself will be explaining it far better than me, and the Street will understand it instinctively.

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