The degree of intermediation by the Federal Reserve in the issuance of US Treasuries hit a record in Q2, accounting for just under 50% of all net UST issuance absorption. This is a startling number, as the Fed's $164 billion in Q2 Treasury purchases dwarfs the combined foreign/household UST purchases of $101 billion and $29 billion, respectively, over the same time period. In fact, the Fed was a greater factor in UST demand than all three traditional players combined: Foreigners, Households and Primary Dealers, which amounted to a $158 billion in net Q2 purchases.

This dramatic imbalance puts a lot of question marks over how the upcoming hundreds of billions in incremental Treasury purchases will be soaked up, now that QE only has $15 billion of capacity for USTs: with Households lapping up risky assets it is unlikely they will look at Treasuries absent some dramatic downward move in equities, while Foreign purchasers, which many speculate are in a game of Mutual Assured Destruction regarding UST purchases, have in fact been aggressively lowering their purchases of Treasuries (from $159 billion in Q1 to $101 billion in Q2, an almost 40% decline in appetite!). Will the US make these purchases much more attractive come October when QE for USTs ends? And if so, what kind of rates are we talking about? One thing is certain: in terms of priorities of the Federal Reserve, keeping the equity market buoyant, is a distant second to ensuring successful auction after auction well into 2010. After all there is near $9 trillion in budget deficits that need financing over the next 10 years.

From Morgan Stanley:

Flow of funds: The Fed also released its flow of funds data for Q2 on September 17. The main points are that: Households reduced Q2 Treasury purchases from their blistering pace in Q1

Foreign accounts reduced Q2 UST purchases as the Fed ramped up Q/E ops

Bank Q2 purchases remained anemic despite the fall in other lending options

Broker/dealer purchases were high but not sustainable, expect Q3 moderation Households out…The salient points here include confirmation that the ‘households’ bid for $377 billion Treasuries in Q1 was a one-time reallocation trade as this account took down a much smaller $29 billion in Q2. We were afraid that this flow would not be sustainable, as the ‘households’ category really includes non-profits and other organizations that simply performed a one-time reallocation trade out of risky assets after their horrid performance in Q4 of last year.

Fed nudges out foreign bid…What is a bit worrisome at first glance is the slowdown in Treasury purchases by ‘foreign’ accounts from $159 billion in Q1 to $101 billion in Q2. Part of this likely reflects the crowding out of foreign investors by the Fed’s Treasury QE program which bought $164 billion Treasuries in Q2 (or close to 50% of the quarter’s net issuance) after a mere $16 billion purchase in Q1.

We anticipate this crowding out to continue in the Q3 data but for foreign accounts to return in Q4 once the Fed’s program expires. Bank buying still not large enough…While ‘banks’ have been ramping up their Treasury holdings with the latest quarter-on-quarter increase of 11%, the corresponding notional amount of $14 billion is still a bit of a disappointment considering the lack of alternative investment opportunities (e.g., C&I loans, home equity lines and consumer lending have all decreased in Q2). In fact, the ‘broker/dealers’ category experienced a much larger increase of $28 billion in Q2. This is generally consistent with the trend we’ve seen in the primary dealer positioning data from the Fed in for the first half of 2009, when primary dealers were reducing their Treasury shorts as they were also reducing their riskier longs in order to bring down the size of their balance sheets. With broker/dealer balance sheets now closer to the right size, we anticipate the broker/dealer buying has slowed down in Q3.

All else equal, these are precisely the questions that keep the Chairman up at night. The answers should present themselves quote soon.