Fed Surpasses China in Treasury Binge

NEW YORK ( TheStreet) -- Data released by the Treasury Department on Wednesday morning indicated that with the Fed's $972 billion in Treasury holdings it has surpassed China's $906 billion in Treasury securities. And with more QE2 purchases on the horizon, the Fed lead over China in the U.S. paper race is likely to be extended.

The Treasury data on China's total Treasury holding exposure is on a two-month lagging basis, as of October 2010. China has been selling longer-term bonds and focusing on shorter-term issues recently, a trend that was evident in the October numbers also.

As for Japan, even as its total exposure to Treasury securities increased in October to its highest level in a year -- and China remained the largest foreign holder of Treasury paper -- Japan was close to overtaking China for second place, while the Fed pulled away from both.

Market analysts and economists were saying that the most recent Treasury buying data showed less enthusiasm from foreign participants for the U.S. government paper, especially the longer-term bonds.

For months, Fed hawks have been expecting the Fed versus China event to occur, given the rapacious buying of government securities that has become synonymous with Fed policy. Still, if it was a fait accompli for the Fed to overtake China as the king of treasury holdings, it's in the least another notable moment in the long-running debate over whether the Fed's actions are leading the U.S. down a path of inflation and speculative asset bubbles.

"I'm not one of those people worried about China holding too much debt or the Fed exceeding an arbitrary benchmark, but the data shows how big the Fed has become in this market, and the market distortions that Fed buying is causing," said Nicole Gelinas, a scholar at the Manhattan Institute and one of the signers of a recent high-profile open letter sent to the Fed by think tank e21 that criticized its monetary policy.

The Manhattan Institute scholar said the real concern should be a Fed monetary policy that is hiding the truth of a financial system that is still broken. "It's not just Treasury securities but mortgage securities and everything that the Fed is buying," Gelinas said.

Gregory Hess, an economics professor at Claremont McKenna College and another participant in the e21 open letter to the Fed, said that the Fed's balance sheet is very large now, which poses risks, and with QE2 it will get bigger, which poses even more risks.

"Given the volatility and movement of global markets for government debt, the asset side of the Fed's balance sheet is now increasingly exposed to potential large capital losses. Of course, how the Fed is funding these purchases, by creating liabilities, is also of concern to those who worry about future inflation. These purchases are not a free lunch. The Fed is increasingly buying asset risk and inflation risk," Hess said.

The Fed held more than $1 trillion in mortgage-backed securities as of Dec. 8.

Fed critics have maintained in opposition to QE2 that the policy will lead to hyper-inflation, as well as asset bubbles across the financial system.

Gelinas, for her part, said that she's less worried about hyper inflation at the moment than the widespread distortion of price signals throughout the financial industry, and a lack of a market-based counter to the Fed-triggered price distortions.

"The Fed is becoming the big price maker in the market and that creates a bigger risk on the market bubble side than on the inflation side of the argument, at least in the short-term," the Fed critic said.

Diane Swonk, chief economist for Chicago-based Mesirow Securities, responded to the latest Treasury holdings data with the counter-argument that it was the right move at the right time. "Just imagine how high rates would be if the Fed had not acted.... This is part of the reason the QE2 was needed," the economist said in an email to TheStreet.

Even Fed critic Gelinas said that keeping interest rates low in a slow economy is justifiable. "It's fine to have low interest rates in a downturn, and I'm not one of those who think we can't have a moderate decline in the dollar, but interest rates are low enough, and there's no reason to go to these extraordinary measures," Gelinas said.

It all boils down to the criticism of the Fed that it's all smoke-and-mirrors when it comes to Bernanke's policy, or at least procrastination -- with the Fed trying to push more money through the financial system as a distraction from dealing with the larger issue of fixing the system.

"There's no market discipline, and the Fed is using QE2 to ignore a financial system that is still broken. That doesn't set the stage for a good recovery," Gelinas said.

The comprehensive Treasury data released on Wednesday, showed that the monthly net foreign capital inflow was $7.5 billion, compared with an inflow of $80.1 billion in September.

"The broad contours of this report are that foreigners bought fewer U.S. assets, and that's the continuation of a trend, but it's a short-term trend," said Robert Perli of ISI Group, a Washington D.C. brokerage and investment advisory firm. Perli added that there were a host of reasons why one should not read too much into the data.

Since there is a two-month lag on the data, the decrease in sovereign buying of U.S. government paper could be linked to the decline of the dollar in the September-October period. There was also market uncertainty related to how QE2 would take shape previous to November, which could have kept foreign buyers out of the government bond market. Finally, China may also be diversifying its asset base.

Perli, who worked for the Fed Board of Governors for eight years before joining the D.C.-based brokerage and investment company, said with the Fed proceeding at $75 billion a month in purchases as part of QE2, and another $25 billion to $30 billion because of reinvestment of mortgage pre-payments from the MBS market, it's difficult to imagine China even keeping pace with that Treasury buying.

Another ISI Group official was among those signing the open letter to the Fed criticizing QE2, but Perli says all the government paper buying is water under the bridge as far as the market criticism of Fed policy. "The Fed is just carrying out what it said it would do a month and a half ago, and all the opinions expressed for and against, most against, are just the rehashing of old arguments at this point."

The ISI Group official said he still believes QE2 will have a positive, albeit marginal impact on the markets, and it will be somewhat smaller than what the Fed control of the federal funds rate accomplishes during normal conditions. In the end, though, the broad market repercussions are the same: inflation expectations rise, stocks rise, and the dollar declines. It's standard monetary policy, and was only used by the Fed because the fed funds rate was already at zero, Perli said.

"If they affect the markets in the same way by buying treasuries or by lowering the federal funds rates, I don't see a difference," Perli added.

The former Fed official didn't deny the risk of inflation, but said that he believes the Fed position that it can raise interest rates quickly if needed, though with less precision than during normal economic conditions. "The market reaction to QE2 has been textbook. QE2 isn't supposed to be a game-changer. The smoothing of the business cycle is the objective of monetary policy. It tends to make valleys less deep at the expense of peaks being less pronounced," Perli said.

-- Written by Eric Rosenbaum from New York.

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