Gridlock Good for Treasuries With Gap to Bunds Narrowing
The big winner in the battle over the U.S. government budget may be the bond market, as investors say for the first time since the onset of the financial crisis they see lawmaker resolve to trim the $1 trillion deficit.
“The market doesn’t care where you cut, as long as you are cutting, and we are starting to see that,” said Tad Rivelle, head of fixed-income investment at Los Angeles-based TCW Group Inc., which oversees about $115 billion. “The budget-cutting environment is bond friendly.”
Optimism that Congress will rein in spending has driven yields on 10-year U.S. government notes to the lowest level relative to German bunds since September. Traders are paying the least to insure Treasuries against losses with credit-default swaps than at any time since August, according to CMA prices.
Budget cuts would mean the U.S. wouldn’t sell as much debt, which has grown to $9.13 trillion in marketable Treasuries from $4.34 billion in mid-2007 as the government boosted spending to pull the economy out of recession.
A shrinking bond market may help contain borrowing costs, allowing Treasury Secretary Timothy F. Geithner to continue financing the deficit at some of the lowest interest rates on record.
“Despite the political back-and-forth, any headwinds on spending cuts provide a good environment for Treasuries as the tone is shifting in the right direction,” said Jack McIntyre, a fund manager who oversees $21 billion in debt at Brandywine Global Investment Management in Philadelphia.
U.S. Congress leaders and President Barack Obama agreed late on April 8 to cut about $38 billion from federal spending this year, pulling the government back from the brink of a shutdown. The final compromise slashes about $23 billion less than Republicans had initially sought, yet tens of billions more than Democrats originally said they could accept.
Ten-year yields rose 13.5 basis points last week, or 0.135 percentage point, to 3.58 percent in New York, according to Bloomberg Bond Trader prices. The benchmark 3.625 percent note due February 2021 fell 1 4/32, or $12.50 per $1,000 face amount, to 100 11/32. The yield was 3.60 percent today as of 11:01 a.m. in New York.
Although yields increased in the five days ended April 8, they are down from 3.88 percent a year ago and remain below the average of 5.22 percent over the last two decades even with the U.S. projected to post a deficit in excess of $1 trillion for a third-consecutive year.
Treasury 10-year yields will remain below 4 percent through year-end, according to the median forecast of 70 economists in a Bloomberg News survey.
The difference between 10-year U.S. and German yields narrowed to 5 basis points on April 4. As recently as February, Treasuries yielded almost 50 basis points more than bunds.
Derivatives tied to U.S. government debt show investors’ perceptions of America’s creditworthiness is improving.
Credit-default swaps on Treasuries fell to as low as 36.2 basis points last week, down from this year’s high of 51.5 basis points on Jan. 27 and last year’s high of 59.7 in February. The price levels are the seventh-lowest of 51 sovereign debt markets tracked by Bloomberg and CMA.
Low borrowing costs mean that the U.S. is spending less to service its debt as a percentage of gross domestic product. Interest expense was 2.7 percent of GDP in fiscal 2010 ended Sept. 30, down from 3.8 percent in 2001, the last time the U.S. had a budget surplus, according to data compiled by Bloomberg.
Any optimism that the deficit will be reduced is misplaced, according to Larry Milstein, managing director in New York of government and agency debt trading at RW Pressprich & Co., a fixed-income broker and dealer for institutional investors.
At about 10 percent of the gross domestic product, the U.S. deficit is biggest of any government rated AAA, according to Fitch Ratings.
“They really have to take more significant action to cut spending before we see a longer term impact on Treasuries,” Milstein said. “The billions that are being cut are nothing compared to the trillions that we have to deal with.”
Bond bears say the only thing supporting the Treasury market is investors seeking safety amid geopolitical turmoil and uprisings in the Middle East in North Africa, and the nuclear crisis in Japan following a record earthquake and tsunami.
European Bond Markets
Europe’s bond markets show what can happen to nations that fail to get their fiscal spending in order. Within the last year, Greece, Ireland and Portugal have sought European Union and International Monetary Fund bailouts after their debt yields rose to records.
“Failure to reduce the budget deficit and stabilize public debt would, eventually, erode confidence in U.S. sovereign creditworthiness and its AAA status,” Fitch said last week.
The rising deficit is failing to deter international investors and central banks from U.S. financial assets.
As of January, $4.45 trillion of Treasuries were owned by investors outside the U.S., up from $3.7 trillion a year earlier, according to the latest government data.
The dollar’s share of global currency reserves stood at 61.4 percent at the end of 2010, little changed from 61.5 percent in 2009, the IMF in Washington said March 31. The euro’s share dipped to 26.3 percent from 27.9 percent.
Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., last month set a bet against U.S. government-related debt and boosted cash to be the largest of the Total Return Fund’s holdings.
Pimco’s $236 billion fund had minus 3 percent of its assets in government and related debt, the Newport Beach, California- based company said on its website, after reducing the position to zero in February.
The Total Return Fund can have a negative position by shorting or using other strategies. Shorting is borrowing and selling an asset in anticipation of making a profit by buying it back after its price has fallen.
“The U.S. is not Ireland, nor is it Greece, nor is it Portugal,” said George Goncalves, head of interest-rate strategy at Nomura Holdings Inc., one of 20 primary dealers that trade directly with the Federal Reserve. “Our foreign investors as well as those who have to be invested in liquid rate products are not going to be deterred or hold back from buying when they have to because of this event.”
During the last government shutdown in 1995 bonds rallied, with two year notes falling almost 30 basis points to 5.17 percent. The Treasury had about $3 trillion in marketable debt outstanding then.
‘Smoke and Mirrors’
Bonds also look attractive on the prospect that budget cutbacks will lead to reduced federal support for municipal governments, slowing the economy, said Jeffrey Gundlach, who runs DoubleLine Capital LP in Los Angeles.
“You are creating a smoke and mirrors recovery based on money that is unsustainable so you need to either raise taxes or cut government spending,” said Gundlach, who was a finalist in 2009 for Morningstar’s fixed-income manager of the decade. “Either of those things will be a body blow to the economy.”
President Barack Obama said last week that too severe budget cuts threaten the recovery just as it is gaining momentum. Gross domestic product may expand 2.92 percent this year, according to the median of 89 estimates in a Bloomberg News survey.
The International Monetary Fund lowered its forecast for U.S. growth this year, predicting higher oil prices and the pace of job gains will restrain the recovery.
The world’s largest economy will expand 2.8 percent this year, down from the 3 percent projected in January, the Washington-based IMF said today.
“The budget cuts are drops in the bucket but it is a sign that they are willing to start chipping away at this unsustainable debt situation,” said Anthony Valeri, a market strategist in San Diego at LPL Financial Corp., which oversees $293 billion of assets. “The bigger issue is the debt ceiling.”
The Treasury estimates the Congressionally mandated borrowing limit of $14.29 trillion will be reached by mid-July at the latest. Republican lawmakers such as Representative Michele Bachmann of Minnesota say they won’t vote to raise the country’s borrowing threshold without further slashing spending.
Since the government shut down non-essential services in 1995 the borrowing threshold has been increased 12 times. In half of those instances, Congress waited until the ceiling had been reached before it was adjusted.
If Congress does not raise the limit in time, the U.S. would need to cut critical payments and would see a surge in interest rates, Geithner told Congress on April 5.
“The consequences of that would be catastrophic to the United States,” he said. “It would make the crisis we went through look modest in comparison.”
As the Treasury moves closer to the debt ceiling, it has cut the amount of Supplementary Financing Program bills, or SFPs, it sells on behalf of the Fed by $195 billion.
That has removed securities from circulation that traders use as collateral in the repurchase agreement market, causing them to look to Treasuries as a substitute. That is further helping to contain yields, according to strategists at Zurich- based Credit Suisse Group AG, another primary dealer.
“Both Democrats and Republicans know that to have true potential to reduce the deficit entitlement spending must be addressed more directly, and the market trusts that they will, or the market will force them to,” Brandywine’s McIntyre said.
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