The great Andy Busch of BMO Capital Markets sees some problems down the road:
It’s called carry, but not like currency carry. As most know, banks can fund themselves at 0.1%-0.25% as the Federal Reserve keeps Fed Funds at 0.0%-0.25%. Then banks are incentivized to find the safest, highest return they can with this cash.
Then where is this cheap money going? Why back to the US Treasury! Banks earn a somewhat risk free return on their cheap money from the Fed by purchasing US Treasury securities.
But there’s one more big incentive for banks to do this carry trade. If they buy something other than Treasury securities, they have to set aside a percentage of the assets value based on the risk weighted asset rating. This carry is only limited by what regulators will allow the bank’s leverage ratios to reach.
As the world looks to see how the massive US Treasury auctions are going, don’t be fooled into thinking that the US government can easily fund itself because the markets have confidence in defect reduction down the road. As the economy recovers and the business environment shifts, this bank-Treasury carry trade incentive will be reduced as the Fed raises interest rates and the cost of funding the carry goes up.
Therefore, the appetite for US government securities will be reduced as well and we’ll get a much better view of how the world feels about the US massive fiscal deficit.