Posted by Joseph Y. Calhoun, III

I wander over to the NY Fed’s website at least once a day to see what they’re up to. The NY Fed is responsible for purchasing mortgage backed securities, Treasuries and Agency bonds that are part of the Fed’s quantitative easing program (or credit easing as they refer to it; whatever). I find it interesting to see the amount tendered into these auctions because it gives an indication of the willingness to hold Treasuries. For instance, take a look at the coupon pass that was conducted today:

Operation 1 - RESULTS
Operation Date:		08/06/2009
Operation Type:		Outright Coupon Purchase
Release Time:		10:15 AM
Close Time:		11:00 AM
Settlement Date:		08/07/2009
Maturity/Call Date Range:		05/15/2016 - 05/15/2019
Total Par Amt Accepted (mlns) : $7,000   Total Par Amt Submitted (mlns) : $48,256
Inclusions:
CUSIP ID Security Description Par Amt Accepted ($) 912810DW5 T 07.250 05/15/16 160,000,000 912828KZ2 T 03.250 06/30/16 310,000,000 912828LD0 T 03.250 07/31/16 4,753,000,000 912828FQ8 T 04.875 08/15/16 1,657,000,000 912828FY1 T 04.625 11/15/16 0 912828GH7 T 04.625 02/15/17 0 912828GS3 T 04.500 05/15/17 0 912828HA1 T 04.750 08/15/17 1,000,000 912828HH6 T 04.250 11/15/17 7,000,000 912828HR4 T 03.500 02/15/18 0 912828HZ6 T 03.875 05/15/18 0 912810EA2 T 09.125 05/15/18 112,000,000 912828JH4 T 04.000 08/15/18 0 912828JR2 T 03.750 11/15/18 0 912828KD1 T 02.750 02/15/19 0 912828KQ2 T 03.125 05/15/19 0

They bought $7 billion but $48 billion was tendered. That’s a lot of bonds that somebody wants to get rid of. Who? Well, most likely the primary dealers who have to buy at the regular Treasury note and bond auctions conducted by the Treasury Department. How do I know? From Zero Hedge:

In a brilliant piece of investigative reporting, Chris Martenson (original article here) has uncovered that the Fed, merely a week after issuing $28 billion in 7 year bonds (which Zero Hedge discussed previously) via its puppet, the US Treasury, of which $10 billion ended up being purchased by primary dealers, has turned and bought 47% of the primary allocated bonds in Open Market Purchases.

Yes, it is brilliant reporting. I visit the NY Fed’s website every day and I didn’t notice it so, kudos to Chris (although I did post something similar last week). Why is this important? Well, last week, the 5 year Treasury auction was, well to be blunt, a flop. The 7 year auction was scheduled for the next day and there was a lot of concern - well, at least I was really concerned - that it would go badly as well. If bidders didn’t want the five year issue why would they want something with a longer maturity? We know that China and Brazil, to note just two, have recently been big buyers of T bills (short term debt)  and sellers of longer maturities. So how did the auction go? Well,  bidders had a change of heart overnight and the seven year auction went swimmingly. Or so we thought…

So did the Fed and Treasury tell the dealers to make it look good and then allow them to unload some of  the issue this week on the Fed? I don’t know and I really don’t like conspiracy theories, but what is the alternative explanation? The stakes are high; two lousy auctions in one week might make some current Treasury holders a little nervous. Of course, having the Fed take some of the issue at the auction would make the largest holder - China - nervous so that wasn’t an option. The Chinese have already expressed their deep concern about our deficit and the potential inflation that could result from the Fed monetizing the new debt. So getting the dealers to buy at the auction and then relieving them of the bonds in short order would seem a good solution as long as no one like Chris Martenson comes along. Bernanke’s transparency initiatives seem to have succeeded beyond his wildest expectations.

The Fed is caught in a trap of their own making. As they expected, the market for the securities they are buying has been distorted by their presence. Rates on those securities are less than they would be absent the Fed’s entry to the market - for now. The problem is that the amount of Treasuries they committed to buy is such a small fraction of the market that they can’t control it. If too many sellers enter the market, the Fed can’t buy enough to keep rates down. What can they do? If they raise the amount of the purchases, inflation expectations could rise, perhaps by a lot. If they back out of the market, they run the risk that rates continue to rise and choke off the recovery. A nasty side effect could be a rapid fall in the dollar which would further inflame inflation fears.

I believe part of the problem is the perception - I would say reality - that Congress has no ability to stop spending. Extending the “cash for clunkers” program was a measly $2 billion but it sends a message to the market that Congress has no impulse control. The discussion of an additional trillion dollars of debt to pay for healthcare reform cannot give much comfort to current Treasury and dollar holders either. We may have reached the point where the rest of the world refuses to fund our irresponsible spending. We have 10 and 30 year auctions next week so we’ll find out soon whether this revelation has an effect.

Over the years I’ve watched a lot of emerging market economies get in trouble with too much debt and they always end the same way. The currency gets devalued and we send in the IMF to impose an austerity program in exchange for loans. We won’t be borrowing from the IMF, but a dollar devaluation seems a near certainty. And if we don’t get our fiscal house in order soon, the market will impose the austerity program for us.

Thanks to Zero Hedge and Chris Martenson for alerting us to this. It may have serious implications for my investment strategy.

Update: This story was actually broken by Brian Benton on Financial Sense. Here’s the link to the original story.