The Fed is Painted Into a Corner
March 16th, 2010
David Goldman

China and Japan have been reducing their purchases of US government securities, while US and (presumably) foreign banks have been increasing their holdings.

Since the beginning of the recession, banks have bought about $300 billion of Treasuries and reduced commercial and industrial loans by about $350 billion. Foreign purchases as of January were still running at a $60 billion monthly rate in January–about $195 billion during the last three months for which we have data. That’s an annual rate of nearly $800 billion, or about half the Treasury’s annual borrowing requirement.

But the demand came not from foreign central banks, but rather from “other foreigners.” Most of this reflects use of the carry trade by foreign banks, or hedge funds, who are doing exactly what the American banks are doing: borrowing at 0.25% from central banks and lending it back to the US government at 1% or 2%, depending how far out the curve they go. The demand isn’t not coming from the oil exporters, who appear to be net sellers. On a geographic basis, the main buyers are “United Kingdom” and the “Caribbean,” that is, banks and hedge funds.

Raise rates and the carry trade comes crashing down. And so does the Treasury market and the mortgage market and the US economy. The Fed is stuck with loose money just as the Bank of Japan was during the 1990s, and for the same reasons.

A table of relevant data can be found at original article