Bond investors follow interest rates as predictors of financial crises, but it turns out they're a poor indicator
With all the dire talk about America's public finances, you might think that investors would be spurning Treasuries. Instead, bond yields are low, as appetite for U.S. securities remains strong. Treasury Secretary Timothy Geithner takes comfort from the government's ability to borrow at low interest rates. "There's a lot of confidence" in America's capacity to meet its commitments, he says. Clearly, the bond markets are on to something.
Or are they? History suggests that bond investors, far from being unerringly clairvoyant, can be a pretty dim bunch. A study of 116 financial crises in 25 countries found that rates did poorly in foreshadowing financial difficulties, says Carmen Reinhart, a co-author of the analysis. European debt markets were "complacent" about the growing repayment risks there "even three years ago," says James Bullard, president of the Federal Reserve Bank of St. Louis.
When the alarm bells start ringing, though, watch out. "People don't worry about credit risk very much until suddenly they worry about it a lot," says Jay Mueller, senior portfolio manager for Wells Capital Management. "Then you can get a panic."
The yield on 10-year Treasuries has actually fallen in the last couple of months as data from durable-goods orders to personal consumption have come in weaker than anticipated. That means growth is not robust enough to spur rate increases that would make current bond yields unattractive.
The overall situation is hard to interpret, though. "Bond investors are in the midst of a tug of war, with debt, deficit, and therefore credit risk starting to flash yellow, but pure interest rate risk—'Is the Fed likely to hike rates quickly? Is the economy hitting a soft patch?—'flashing green," says Mohamed El-Erian, chief executive officer of Pimco, which runs the world's largest bond fund.
The market has "missed a lot of crises" over the years, says Reinhart, a former International Monetary Fund official who is now a senior fellow with the Peterson Institute for International Economics in Washington. "Very often, interest rates are a coincident, rather than a leading, indicator" of trouble, she says. The research she did with fellow economists Morris Goldstein and Graciela Kaminsky looked at crises from 1970 to 1995, focusing on everything from bank deposit rates to yield spreads. In signaling financing problems, she says, "None of them worked well."
The European bond markets didn't foreshadow the sovereign-debt crisis that began at the end of 2009, when Greece revealed that its budget deficit would be more than three times previous projections. The yield on Greece's 10-year notes averaged 4.8 percent in 2008 and 5.2 percent in 2009. It closed at 17.7 percent on June 15. In 2009, the Portuguese government paid only 0.93 percentage points more than the Germans to attract investors to Portugal's 10-year notes. Then contagion from Greece forced Portugal to seek aid from the European Union and the IMF. The Portuguese are now paying 7.7 percentage points more than the Germans.
Bullard of the St. Louis Fed draws some harsh lessons from the experience of European bond investors. "If you look at U.S. debt and deficit numbers, we're worse than some of the worst offenders in Europe," he says. The White House has forecast the deficit will hit $1.6 trillion in the year ending Sept. 30, equivalent to 10.9 percent of gross domestic product. "You cannot take too much comfort from the fact that 'Oh, nobody is worried about this today,' because when the crisis is upon you, it will really hit," he says. "It's like the markets are almost asleep about the whole issue until one day you wake up and it becomes the primary issue."
Analysts have cautioned for years that the U.S. budget deficit could lead to a blowup in the Treasury market. It hasn't happened. In January 2004, former Treasury Secretary Robert Rubin joined with Decision Economics Chief Global Economist Allen Sinai and future U.S. Budget Director Peter Orszag to warn of the "risk of financial and fiscal disarray" from sustained deficits. Yields have stayed very manageable since.
Technical factors help explain why bond markets often are slow to recognize credit risks, El-Erian says. In figuring out which investment firms to put their money with, investors want to know how money managers fare against model portfolios. A model moderate growth fund, for example, should contain Treasuries for stability and stocks for capital gains. Most model portfolios have Treasuries in their mix. So to be sure they at least match the performance of these models, money managers stock up on U.S. bonds. "It takes a major shock to get them to change their portfolios," says El-Erian.
Foreign central banks are also playing a role by increasing their purchases of U.S. Treasuries. As U.S. dollars paid to local exporters flood these countries, the central banks convert the greenbacks into Treasuries to keep them from pouring into their economies, sparking inflation and speculative behavior. Central bank buyers may be less sensitive to deficits in the U.S., says Kenneth Rogoff, a former IMF chief economist who is now a professor at Harvard University. "A large percentage of U.S. debt is now owned by official holders, so it's not clear if interest rates are sending market signals under those circumstances," he says. Foreign central banks and other institutions held 41.5 percent of outstanding marketable U.S. government securities as of June 30, 2010.
Investors may also be putting money into Treasuries because they see few alternatives, Mueller says. Japan has worse fiscal problems than the U.S., while Europe continues to struggle with its sovereign-debt crisis. "You've got to own something," he says.
The wake-up call is often the disclosure of "hidden debt," Reinhart says. That happened with Greece when its budget deficit proved larger than projected. The same could occur with the U.S., she says: "We have a lot of contingent liabilities." Standard & Poor's (MHP) flagged what it called America's "contingent fiscal risks" in revising its outlook on U.S. Treasury debt to negative on Apr. 18. S&P cited potential losses on government-guaranteed student loans and mortgages backed by the Federal Housing Administration. Medicare won't have enough to pay full benefits by 2024, and Social Security's cash to pay full benefits runs short in 2036, according to a U.S. government report in May.
Daniel Fuss, who started on Wall Street in 1958 and co-manages the $21 billion Loomis Sayles Bond Fund (LSBDX), is betting the U.S. will try to deal with its debts by fostering inflation, which would reduce the real value of its liabilities. "I think that's the way it's going to go," says Fuss, 77, who has lowered the average maturity of the debt in his fund to 9 years from 10 years to protect against higher inflation. "The question is, how unsettling, how rowdy does the bond market get in the process?"
The bottom line: Investors have a spotty record in predicting debt crises, suggesting that low Treasury yields may be downplaying fiscal risks in the U.S.