There are parts of the world of financial markets and the banking system that are both vital and at the same time opaque. Unlike the stock market that gets all the attention, with 24/7 coverage and constant punditry, these other corners of market activity provide a sort of plumbing to the economy. Like water pipes in a home, commercial paper markets, mortgage markets and bank overnight lending activity are constantly active, almost always taken for granted and tend to only get attention when something goes wrong.
Back in 2008 I distinctly remember lamenting how absurd it was that the risk from housing speculation in California could get baked into the national banking system through complicated mortgage securities the typical individual investor wasn’t even aware of, and almost take the entire financial system down.
Sure, a few market prognosticators were crying lonely in the wilderness, and a couple clever, now high profile, investors took bets against this system that made them rich, and got them books and Netflix movie deals to brag about it, but the majority of both professional and individual investors were mostly blindsided by the crisis. I vowed at the time that going forward I would do my darndest to pay attention to the unclear, boring parts of the financial system for signs of stress. I have been attempting to do so ever since.
This week one of the boring, often ignored, kind of complicated areas of the financial markets started to get an unusual level of attention. The part of the financial system getting this attention is the system the U.S. Treasury uses to borrow money and issue bonds to finance the operations of the federal government.
It’s easy to get overwhelmed and dismiss the numbers we are regularly subjected to when it comes to federal government finances. A trillion here, two trillion there, a hundred billion to Ukraine, the scope of numbers is truly inconceivable, but these numbers are, in fact, real money. When the government says it is going to run a $1.7 trillion deficit, it must raise and borrow this money from the world financial system. The process it uses to do this is a complicated auction process.
Earlier this week, the Treasury Department announced it was going to auction $776 billion of various government securities during the fourth quarter of 2023 to fund operations. Whereas the process of announcing the amount of bonds it intends to sell is a regular occurrence, the announcement is rarely a “page one” story. This week it was.
I will speculate as to why. First, this is a ton of money. It would be a natural question to ask, “where is all this money going to come from?” I think this question begets the attention and potential concern as well. The last few U.S. Treasury auctions did not go entirely flawlessly, in that the demand level for the Treasury bonds being issued was relatively week, driving the price of this money, or the yield on the bonds, higher than anticipated.
The participants in these auctions are typically institutional investors, such as mutual funds and pension funds. It is feasible that these investors simply don’t have the capital to absorb all this huge new supply of bonds. There is, however, another type of participant in these auctions called primary dealers.
Primary dealers are currently 24 large money center banks, or investment banks. Most of the primary dealers are financial firms easily recognized by the public. These primary dealers are bound by the government to provide competitive bids in every Treasury auction. As money center banks, it is generally assumed that demand from the primary dealers will be sufficient to fully fund the Treasury auction, and this is typically the case. But as we’ve said, the government needs to borrow an obscene amount of money in the next few months. What if even the primary dealers don’t have enough demand for all these new bonds?
Well in this case, the Federal Reserve bank will use a couple different mechanisms to fund the primary dealers' purchase of the bonds. While the Fed is not allowed to buy bonds directly from the Treasury, it can use the primary dealer system to prevent the failure of the auction and make sure the government can borrow the money it needs.
The rub is, the process of fulfilling the needs of the auction also increases the supply of money in the financial system, which as we’ve discussed many times in this column has the potential to exacerbate inflation, just at the time when the Fed is doing everything it can to reign in the inflationary pressures in the U.S. economy.
In order to manage the inflationary pressures in our economy, ideally government fiscal policy and Fed monetary policy would be aligned. In many ways the opposite is true at this time, and the Fed may be getting backed into a corner. Investors are starting to take notice.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. No investment strategy can guarantee a profit or preserve against loss. Past performance is not a guarantee of future results. This material may contain forward looking statements; there are no guarantees that these outcomes will come to pass.
Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.
