The issue that is set to move to center stage, sometime in the next nine months, has less to do with theoretical inflation, or theoretical deflation. Rather, the question of which ‘flation we experience next year is likely to be determined by the exploding supply of US Treasuries.

Sure, banking systems worldwide are being recapitalized, as governments attempt to replace part of the debt currently being destroyed. And sure, some of that capital or even alot of that capital is not getting into the system, and is being hoarded. And yes, there is deflationary pressure at the margin right now, at least on a directional basis, as the price of most assets continues downward. On the opposite side of the ledger, USD cash and JPY cash strengthen.



However, it will not be possible for the USD to strengthen past the moment that auctions of US Treasuries start to go badly, as buyers either refuse to buy or start to demand much higher rates (lower prices) for those bonds. When that point is hit (or anticipated) the USD will be unable to strengthen and the full effects of the current reflationary efforts will rush to center stage, as our purchasing power heads downward again. So in a way, the inflation-deflation debate here in the US now moves directly to the fate of the US Treasury bond market.

On the matter of anticipation: investors in the US Treasury bond market can roughly be divided into two groups. The first are price insensitive buyers like foreign governments who recycle dollars, and large pension funds who buy because of investment mandates. The second are discretionary buyers, like mutual funds, hedge funds, individuals. The second group will very likely have started exiting the US Treasury bond market before there are actual problems with rolling over the maturing debt. This could begin at any time. And there are hints the reactions may have already begun.



I have watched the growth of the public debt for years. It was only 18 months ago that I wondered when the debt limit ceiling would be raised beyond 10 Trillion. As you can see in the above graphic, we have exploded past that level now. With more to come.

My view is that because current events in equity and credit markets are so dramatic, the market has not yet paid attention to the coming boundary, of debt-ology. However, I expect participants to direct their thinking this way quickly, once the intensity of the crisis lessens. I see two areas, where markets will inevitably focus.

First, The FED could be getting close to more unconventional measures, like direct buying of long-dated Treasuries to bring long-rates down. Second, the quantity of new Treasury issuance, both in train and intended, is so gargantuan that it’s not clear how the world would be able to actually take up the supply. There may be structural limitations. Simply put, it’s not clear there’s enough available capital in the world to increase the US debt position further. After all, we have already been sucking up the world’s savings for most of this decade. It strikes me the only method to ensure this new supply is taken up would be that other central banks would eventually have to monetize the USA, in the same way the USA is monetizing its own banking system. So future Treasury issuance may depend either on our own central bank to monetize it, or for foreign central banks to do the same. When either happens, I’m of the opinion it’s Game Over.

-Gregor

Further Reading:

James Hamilton’s Econbrowser: The Federal Reserve’s Balance Sheet.

Brad Setser’s Follow the Money: Do not doubt this is a real crisis: More on Fed’s Balance Sheet.

naked capitalism: Currency Crisis is Gathering Storm.