Treasury Bond Sale Generates Tepid Response

Last week, the financial markets responded tepidly to a new round of U.S. Treasury bond sales, which raises warning signals over mounting government deficit projections and the higher interest rates they could bring.   

Markets are funny things. Money moves them, regardless from where it comes. When money comes in — like it did last Monday — in a big way, the market moves big as well — the DJIA shooting up 500 points.  Right now, money is coming from the government — especially last week when Treasury announced its up to $1 trillion Public-Private Investment Program to buy troubled real estate-related assets.  

The problem is that the government’s money is still largely the only money that is moving into the market.  As Wednesday’s little-noticed $34 billion Treasury auction of five-year notes demonstrated, the private sector investor is still largely on the sidelines. And it doesn’t take much of a dose of this reality to sober the markets up quickly.

To underscore once again the current crisis’ global nature, the problem began with a London auction of U.K. bonds that fell short of selling all the securities offered.  The problem then migrated to a U.S. Treasury auction, which, while it did not fail as did the U.K.’s, met with less demand than usual — ominously from foreign investors. The news promptly snuffed out a promising tripe-digit DJIA rally (although it did close higher).

The Treasury auction offers another piece of uncertainty in a market already awash in uncertainty.  That uncertainty has taken deep root and even positive economic signals — Wednesday’s 3.4% increase in February durable goods orders and February new home sales showing their first increase in seven months — can not dissipate it in a day.

Granted, the Treasury’s plan to facilitate the purchase of problem "legacy" assets from the books of financial institutions will help remove some of that uncertainty. That program, because it is already funded through existing TARP money — thus removing the vagaries of the political process – should be unaffected by the Treasury auction hiccup.

Still, the public-private investment plan will certainly hold its own surprises.  Essentially an auction itself, assets will come in both below and above estimates. But this is the value of the program — defining through disclosure, both good and bad. The virtue of the Treasury approach is its reliance on the market to determine asset value.  Left to its own devices, the market will "clear" at some price and "some price" is still much clearer than what institutions now face with these assets.

The reason markets so loathe uncertainty, and welcome even bad news over it, is because what markets really exchange is information.  They may trade different commodities and denominate in different currencies, but they all ultimately trade the same thing: information.  Uncertainty is the absence of information, and without it markets can not properly function.  Allowing these troubled assets to be traded, even at deep discounts, will still provide markets the information they have lacked for so long.  And once they have it, they will function in their naturally efficient way.

At the same time markets would seem to be on the verge of gaining some clarity, Wednesday’s weak Treasury auction fires a warning shot across their bow: future interest rate hikes. Last week’s new baseline from the Congressional Budget Office demonstrates how rapidly the federal fiscal situation is deteriorating. Just since January, CBO’s baseline deficit — its projection assuming nothing changes — has increased by $481 billion this year, $436 billion next year, and $1.3 trillion over the next ten years.  At the same time, CBO projects real GDP to fall further ( -3% versus -2.2%) and annual unemployment climb higher (8.8% versus 8.1% ) than just two months ago.   

While fiscal deterioration is not surprising in a recession, it is still unsettling in a market. The Treasury auction foreshadows that investors are already looking to hedge against higher deficits’ impact by demanding increased interest rates today.

So as has been the case for some time, the market both gives and takes away in a single day. It was not stampeded by the threat of higher rates down the road. However, the increasingly real prospect of these higher rates is beginning to exert influence.

Long-term worry may seem a luxury that this hour-to-hour market cannot indulge, that it should take its comfort where and when it finds it. And for the week, it held on to broad and sizable gains — albeit resulting from the government’s sizable investment commitment. Yet any increased clarity it looked so forward to getting comes with a new uncertainty over higher interest rates.  And that is just par for what has proved to be a very rough course.