President Barack Obama knows who is the boss: the bond market.
“Ultimately, what matters is: What do the people who are buying Treasury bills think?” the president told reporters this week, when discussing measures he could take to end the threat of a historic default on the nation’s debt.
Even with the U.S. budget deficit down by more than half since 2009 as a percentage of the economy, the Congressional Budget Office says the government this fiscal year will need to borrow an average of almost $11 billion each week. That’s why Obama is so sensitive to what investors will tolerate.
“The market is the final arbiter of any policy, the ultimate barometer and enforcement mechanism,” says Russ Certo, a managing director at Brean Capital LLC in New York. “The market holds risk-takers and policy makers accountable.”
After weeks of confidently expecting a resolution of the standoff in Washington over the government shutdown and the debt ceiling, bond investors this week began to betray nervousness in their approach to short-term government borrowing.
The yield they demanded at the Oct. 8 auction of four-week Treasury securities almost tripled from a week earlier, Treasury Secretary Jack Lew highlighted in testimony before the Senate Finance Committee yesterday. The government was forced to pay 0.35 percent for four-week borrowings, up from 0.12 percent.
The White House yesterday endorsed a short debt-limit increase with no policy conditions attached, signaling potential support for a Republican plan that would push off the lapse in U.S. borrowing authority through Nov. 22 rather than Oct. 17. Rates for all Treasury bills maturing through Nov. 14 fell in response, while those with due dates between then and Jan. 2 rose. At a meeting with Republican leaders later in the day, Obama neither accepted nor rejected the party’s plan. The two sides will continue discussions.
Obama’s deference to bond investors is reminiscent of the last Democratic president, Bill Clinton, whose economic agenda in 1993 was eclipsed by demands for deficit reduction. The belt-tightening was followed by four straight budget surpluses later in the decade, prompting Alan Greenspan, the then-Federal Reserve Board chairman, to predict the end of the Treasury market. Bond buyers’ clout ebbed.
More than a decade later, surpluses are a fading memory and the bond market has regained its swagger. Yet unlike in the Clinton era when the danger of rising yields kept government spending in check, the market now is exercising discipline only after several years of record federal outlays and borrowing.
“The one market that is behaving more as if a 2008 event is around the corner is the T-bill market -- one must wonder if this is the proverbial canary in the coal mine,” David Rosenberg, chief economist at Gluskin Sheff in Toronto, wrote to clients this week.
Investors’ sudden awareness of the danger in Washington also can be seen in the difference between what banks pay to borrow from each other and the yield on one-month U.S. government debt. This so-called TED spread turned negative this week for the first time since Bloomberg began collecting such data in 2001, meaning investors regard banks as a better credit risk than the U.S. government.
Jack McIntyre, who oversees $44.5 billion at Brandywine Global Investment Management LLC in Philadelphia, said slow economic growth, low inflation, and accommodating central banks explain why 10-year Treasury yields are little changed from Obama’s first month in office, even as federal borrowing has soared.
“Markets can still enforce discipline on policy makers and will if the situation gets way out of hand,” McIntyre said.
Senator Michael Bennet, a Colorado Democrat who worked in debt markets as a managing director of Anschutz Investment Co. in Denver, said Obama will be at the mercy of market sentiment that can sour overnight unless he tackles the U.S. long-term debt.
“Things can change, and you don’t know when that’s going to happen,” Bennet said at a Bloomberg News breakfast this week. “It’s not in your control. It’s somebody else making that decision, saying, ‘I’m not going to buy that paper at that price.’”
Such a loss of investor confidence -- as seen across the periphery of Europe -- would cause borrowing rates to rise for mortgages and other consumer loans as well as government debt.
Presidents from Theodore Roosevelt to John F. Kennedy confronted individual corporations or entire industries. President Harry Truman in 1952 seized the nation’s steel mills in a move later ruled unconstitutional by the Supreme Court.
Modern financial markets are tougher opponents. Clinton took office in January 1993 determined to stimulate the economy with fresh spending to create jobs. Instead, his advisers warned that he risked a bond-market meltdown unless he first focused on cutting the deficit, which had reached 4.7 percent of gross domestic product, its highest level in six years.
“You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of f--- --- bond traders?” Clinton replied, according to “The Agenda,” an account of his economic policy-making by journalist Bob Woodward.
After witnessing the bond market’s power, James Carville, Clinton’s top political operative, quipped: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market,” he told the Wall Street Journal at the time. “You can intimidate everybody.”
Under Clinton, the yield on the 30-year Treasury fell to a low of 4.7 percent in October 1998 from a peak of 8.2 percent in November 1994, while the budget deficit turned into a surplus.
“That strategy worked for Clinton,” said Rob Shapiro, who helped draft the president’s economic plan and is now chairman of the Washington advisory firm Sonecon Inc. “It produced the longest boom on record.”
As budget deficits exploded following the 2008 financial crisis, with the government recording its first trillion-dollar shortfalls in history for four years in a row, many Republicans said so-called bond market vigilantes would demand higher Treasury yields. That hasn’t happened.
Even amid the prospect of the U.S. defaulting on its debt, yields on the 10-year Treasury notes at 2.68 percent are less than half the 50-year average of about 6.5 percent, according to data compiled by Bloomberg.
To many in the market, default remains a remote prospect. William Gross, co-chief investment officer of the world’s biggest bond fund at Pacific Investment Management Co. in Newport Beach, California, called it “almost impossible.”
Washington’s repetitive political standoffs have conditioned Wall Street to expect 11th-hour solutions.
With the federal government partially shuttered and the nation sliding toward a possible debt default, some have suggested that, as a way out, Obama could invoke the 14th amendment to the Constitution, which says the public debt “shall not be questioned.”
Obama earlier this week ruled that out, as well as any of the other unusual maneuvers that have been suggested -- such as minting a $1 trillion coin. He said investors might balk at buying new Treasuries or demand higher interest rates.
“If you start having a situation in which there’s legal controversy about the U.S. Treasury’s authority to issue debt, the damage will have been done even if that were constitutional,” he said. “Because people wouldn’t be sure.”
The $11.9 trillion market in outstanding Treasury securities has more than doubled since mid-2008, when the government ramped up borrowing amid the financial crisis. Almost half that amount is held by foreign investors; an additional $2 trillion is held by the Fed.
The government is on track to borrow $7 trillion more over the next decade, according to the Congressional Budget Office.
As a percentage of the economy, the deficit is expected to bottom out at 2.1 percent in fiscal 2015 before resuming its uphill climb, CBO says. Under current law, debt held by the public would exceed annual output by 2038. The budget office in a recent report said such outsized borrowing would be unsustainable, another reminder of creditors’ power.
“The bond market calls the shots,” says Robert Reich, a professor of public policy at the University of California at Berkeley who was secretary of Labor under Clinton. “All eyes are on the bond market right now.”