Much Ado About Price Discovery

I chafe, instinctually, at the idea that the US government is “running out of room” to issue debt or, more accurately, that investors don’t want any more interest-bearing US dollars.

Most people have a hard time wrapping their minds around the idea that the US is actually doing the world a favor by “borrowing.” America doesn’t have to borrow. And if America stops borrowing, how would exporters around the world recycle their dollar proceeds? Would they sell a cargo of crude and park the dollars in an inert FX trading account (to borrow a joke from an erstwhile friend)? How would emerging markets defend their currencies? How would counterparties collateralize financial transactions? And so on. Too often, we lose track of the fact that the system as we know it won’t function without US government obligations to grease the proverbial wheels.

Beyond that, there’s a very real sense in which the word “borrow” doesn’t even make sense in this context. There’s no dollar mine in China, and the Ghawar is an oil field, not a dollar field. The US can no more “borrow” a dollar than Turkey can “borrow” lira or China “borrow” yuan.

Anyway, the current selloff in US Treasurys is, at a very basic level, just an asset class trying to find a clearing price. A price-insensitive buyer (the Fed) stepped away, and now we’re witnessing something that looks like price discovery.

The problem (or one problem, anyway) is that nobody remembers what price discovery looks like. Price discovery was deliberately suppressed for more than a dozen years after the financial crisis, so what a previous generation of traders might recognize as “an orderly clearing of markets,” as Goldman put it late last week, now appears as an anomalous rout indicative of lost faith in the world’s benchmark security.

Of course, no one would be blamed for losing faith in US government securities. After all, the country is experiencing an acute credibility crisis that recently engulfed even the Supreme Court, and the US has no functioning legislature. As of last week, the “no functioning legislature” talking point ceased to be an exaggeration.

But the repricing at the US long-end probably isn’t the existential moment it’s made out to be. It might not even be a comment on American governance or even on oversupply. Again, you could very plausibly suggest markets are in the process of rationally assessing fair value given a variety of factors including the absence of a price-insensitive bid from the Fed and the prospect of a durable shift in macro fundamentals. I’m not convinced that’s a bad thing, let alone an inherently nefarious development.

And yet, the recent increase in the term premium and the “sticker shock” of 5% following a decade of ZIRP and NIRP, has elicited a sense of panic or, if not panic, then incredulity, from many observers. At the least, it feels like anybody who’s anyone feels compelled to “explain” the situation by reference to something other than price discovery in the absence of a perpetual monthly bid from the Fed.

“With the US Treasury in the process of issuing close to $2 trillion in new supply in the second half of the year, the bond market has taken notice and demanded a higher rate of return to fund that issuance,” Morgan Stanley’s Mike Wilson wrote Monday. “With inflation expectations relatively stable and economic growth showing limited signs of reaccelerating, it appears this move in yields is, in part, related to [questions about] the US government push[ing] the limit of its ability to spend without proper long term fiscal discipline and funding in place.”

Wilson’s explanation is plausible. If it’s not inflation expectations and it’s not a firmer growth outlook, then it’s something else, and that something else might be the appearance of irresponsible fiscal policy, magnified by government dysfunction.

But, again, it’s possible we’re thinking too hard about all of this. It’s possible that 5% is just the fair market price, and that the much discussed 50% drawdown is merely a reflection of how distorted prices were during the post-GFC period, not a referendum on America’s trajectory, fiscal or otherwise.

Wilson readily acknowledged the interplay with QT, but he seemed to assign a lot of weight to other factors. “There may be some growing questions on the sustainability of fiscal programs from traditional bond buyers,” he went on. “The bond term premium has been suppressed over the past decade amid quantitative easing and strong demand from overseas buyers looking to store their savings in a reliable place, but with the Fed no longer doing QE and even shrinking its balance sheet, banks unable to step in and buy and overseas buyers starting to diversify away from the US dollar and/or defend their own currency, it’s unclear who the natural buyer of this significant new supply is.”

If that’s the question —  Who are the “natural buyers” for interest-bearing dollars? — the answer is “everyone.” The real question is about price. Price is a function of demand, but there’ll never be a complete absence of buyers for US Treasurys. Or if there is, something has gone terribly awry such that bond yields will be the least of anyone’s concerns.