In Friday’s FT, former Fed chairman Alan Greenspan writes (our emphasis):
Excess capacity is temporarily suppressing global prices. But I see inflation as the greater future challenge. If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012; earlier if markets anticipate a prolonged period of elevated money supply. Annual price inflation in the US is significantly correlated (with a 3½-year lag) with annual changes in money supply per unit of capacity.
Government spending commitments over the next decade are staggering. On top of that, the range of error is particularly large owing to the uncertainties in forecasting Medicare costs. Historically, the US, to limit the likelihood of destructive inflation, relied on a large buffer between the level of federal debt and rough measures of total borrowing capacity. Current debt issuance projections, if realised, will surely place America precariously close to that notional borrowing ceiling. Fears of an eventual significant pick-up in inflation may soon begin to be factored into longer-term US government bond yields, or interest rates. Should real long-term interest rates become chronically elevated, share prices, if history is any guide, will remain suppressed.
The US is faced with the choice of either paring back its budget deficits and monetary base as soon as the current risks of deflation dissipate, or setting the stage for a potential upsurge in inflation.
So what’s the Fed and Treasury to do, especially if they’re to
dupe convince the market into believing their impressive sales agenda is achievable, and without inflationary follow through?
Well, a lot has been made of some recent tinkering by the Fed on its definition of Treasury auction bidders. The old system which included a looser differentiation between direct and indirect bidders is gone. This is important because the number of indirect bids is usually taken by the market as a proxy for foreign central bank demand.
But as the Across the Curve blog explains (our emphasis):
The new process is really an accounting change and will give a more precise measure of ALL customer interest. Previously many dealers would bid for customers with a direct bid and then sell that award to the client. The bid was not the dealers [sic] and the dealer had no risk in the transaction as the client had agreed to take the bonds at a price.
The Treasury, with the change in procedure, is providing market transparency which was only available before to those who submitted those customer bids as direct bids. That dealer would know that a substantially larger amount of bonds had been “put away” or sold to end users than was actually being reported.
Under the old system the award to the dealers was larger as the customer bid was included in the dealers bid. In that way the total to dealers was misleading as it made it look as though dealers were buying more bonds than they truly were. This gave an unfair advantage to the dealer who submitted the investor bid.
In short, foreign or indirect bidders will no longer be allowed to place bids clandestinely via direct dealer bids. This in the first instance may boost the number of publicised indirect bids, making demand from foreign central banks appear stronger in the short run than it was before.
Here are the key pars from the rule change, as pointed out by Across the Curve:
III. Guaranteed Bids – The UOC contains several provisions to regulate bidders \ in a Treasury auction. We are eliminating a provision at 31 CFR 356.14(a) related to “guaranteed bid” arrangements in Treasury auctions that is no longer needed. Specifically, we are eliminating the provision in 31 CFR 356.14(a) that states, “If a bid from a depository institution or a dealer fulfills a guarantee to a customer to sell a specified amount of securities at an agreed-upon price, or a price fixed in terms of an agreed-upon standard, then the bid is a bid of that depository institution or dealer. It is not a customer bid.”
This particular provision dates back to 1995 when Treasury conducted multiple-price auctions, which are auctions in which each successful competitive bidder pays the price equivalent to the yield or rate that it bid. Prior to the close for submission of competitive bids, certain dealers were entering into arrangements to guarantee their customers \ a price conditioned on the outcome of the auction (e.g., the weighted average yield determined in the auction).\ This provision was added in response to and intended to address that specific practice.
In 1998, Treasury shifted to single-price auctions for all Treasury marketable securities, which are auctions in which all successful bidders pay the same price regardless of the yields or rates they each bid.\ Because Treasury no longer conducts multiple-price auctions, the provision is no longer needed or effective. Treasury expects any depository institution or dealer guaranteeing bids in a single-price auction to reexamine this practice, confirm that the bidder has been properly identified on the bid, and raise any questions with Treasury staff. Questions related to particular facts and circumstances may be directed to the Government Securities Regulations Staff at the telephone number listed above. —————————————————————————
\ The UOC defines a “bidder” at 31 CFR 356.2 to include persons and entities who offer to purchase Treasury securities in an auction through a depository institution or dealer. \ See definition of “customer” at 31 CFR 356.2. \ See 60 FR 13906, March 15, 1995. The “guarantee bid” provision was subsequently moved from the definition of “bid” in 31 CFR 356.2 to 31 CFR 356.14(a) when the UOC was converted to plain language in 2004. See 69 FR 45202, July 28, 2004. \ See November 1998 Quarterly Refunding Statement remarks by Gary Gensler, Treasury Assistant Secretary for Financial Markets (October 28, 1998) http://www.treas.gov/press/releases/rr2782.htm. —————————————————————————
Treasury expects transparency in the submission of all auction bids, including those for customers, to maintain the integrity of the auction process. All auction participants, including bidders, customers, and submitters must comply with Treasury’s auction rules. This rule makes no changes to the general UOC requirements of 31 CFR 356.12 bidding restrictions, 31 CFR 356.13 net long position reporting, 31 CFR 356.14 proper identification of customers, 31 CFR 356.16 certifications, and 31 CFR 356.24 confirmations required from any customer awarded a par amount equal to or greater than $750 million.
Of course, as the above shows, the US Treasury puts its sudden bout of transparency down to a change in the auction procedure itself (to a single-price auction system) – a change actually implemented in 1998.
Which means it took the Treasury 11 years to do something about it.
And hey presto, the number of indirect bids at the Fed’s auction of seven-year paper on Thursday (and through the week for that matter) was pretty impressive, leading to a swift Treasury rally on the back of the news. As Bloomberg reported:
Indirect bidders, a class of investors that includes foreign central banks, purchased 67.2 percent of the offering. They bought 33 percent at the May sale and an average of 33.2 percent at the past four sales. The levels of indirect bidders at this month’s auctions may have been affected by a rule change that eliminated a provision allowing some customer awards to be classified as dealer bids.