Low Yields on U.S. Treasuries No Guarantee Against Fiscal Crisis
Treasury Secretary Timothy F. Geithner takes comfort from the government’s ability to borrow at low interest rates as the budget deficit hits a record high. “There’s a lot of confidence” in America’s capacity to meet its commitments, he told Bloomberg Television.
History suggests that such faith may prove to be misplaced in the long run. A study of 116 financial crises in 25 countries found that rates had a poor track record in foreshadowing financial difficulties, said Carmen Reinhart, a co-author of the analysis and the female economist whose work is most frequently cited by other researchers. European debt markets were “complacent” about the growing repayment risks there “even three years ago,” James Bullard, president of the Federal Reserve Bank of St. Louis, said in a May 18 interview.
“People don’t worry about credit risk very much until suddenly they worry about it a lot,” said Jay Mueller, senior portfolio manager in Menomonee Falls, Wisconsin, for Wells Capital Management. “Then you can get a panic.”
Mueller, who began his investment career in 1982 and whose group at Wells manages about $14 billion, sees the yield on the 10-year Treasury note rising to 3.5 percent by the end of this year as the recent slowdown in the economy proves temporary. Yields could increase further in 2012 if investors lose confidence in the willingness of the U.S. to tackle its budget deficit, he said.
The 10-year yield has fallen in the last couple of months as data from durable-goods orders to personal consumption have come in weaker than anticipated. It slid four basis points to 2.99 percent on June 3, near a six-month low, according to Bloomberg Bond Trader prices, after the Labor Department reported that job growth in May was less than a third of economists’ forecasts and the jobless rate rose to 9.1 percent from 9 percent in April.
“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,” said Mohamed El-Erian, chief executive officer of Pacific Investment Management Co., which runs the world’s largest bond fund out of Newport Beach, California.
The market has “missed a lot of crises” over the years, said Reinhart, a former International Monetary Fund official and University of Maryland professor who is now a senior fellow with the Peterson Institute of International Economics in Washington.
“Very often, interest rates are a coincident, rather than a leading, indicator” of trouble, said Reinhart, who is also a research associate at the National Bureau of Economic Research, the arbiter of U.S. business cycles.
No. 1 Rank
Reinhart is the No. 1 ranked female economist worldwide as of May, based on criteria used to judge the popularity of her work, according to RePEc: Research Papers in Economics, an online database of economic material operated by volunteers in 74 countries.
The research she did with fellow institute economist Morris Goldstein and George Washington University professor Graciela Kaminsky looked at crises from 1970 to 1995, focusing on everything from bank-deposit rates to yield spreads. “None of them worked well” in presaging financing problems, she said. The results were contained in “Assessing Financial Vulnerability: An Early Warning System for Emerging Markets,” a book published by the institute in 2000.
The European bond markets didn’t do a good job of foreshadowing 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, Reinhart said. The yield on the country’s 10-year notes has surged since that news after averaging 4.8 percent in 2008 and 5.2 percent in 2009. It closed at 15.8 percent yesterday.
The spread between higher yields on Portugal’s 10-year notes and those on German bunds averaged just 0.93 percentage point in 2009 in the run-up to Europe’s debt woes. The spread stood at 6.7 percentage points yesterday.
The IMF last month approved a 26 billion-euro ($37.9 billion) loan to Portugal as part of a joint bailout with the European Union. Under the plan, Portugal aims to reduce its budget deficit to the equivalent of 3 percent of gross domestic product by 2013 from 9.1 percent last year.
“If you look at U.S. debt and deficit numbers, we’re worse than some of the worst offenders in Europe,” Bullard said. The White House has forecast the deficit will hit $1.6 trillion in the year ending Sept. 30, equivalent to 10.9 percent of GDP.
“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,” Bullard said. “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 been cautioning for years that the yawning U.S. budget deficit could lead to a blow-up in the Treasury bond market -- and it hasn’t happened. In a paper presented at a meeting of economists 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 in warning of the “risk of financial and fiscal disarray” from sustained deficits.
“Technical factors” play a large role in explaining why bond markets are frequently slow to recognize growing credit risks, El-Erian said. Many money managers measure their performance against market-wide yardsticks that are composed of a set percentage of bonds.
“Especially when it comes to Treasuries, there is a strong benchmark-centric community, either people who run money passively in Treasury space or those that say they are active managers but really are benchmark huggers,” El-Erian said. “It takes a major shock to get them to change their portfolios.”
The growing presence of central banks in the U.S. Treasury market also may make yields less sensitive to concerns about deficits, said Kenneth Rogoff, a former IMF chief economist who is now a professor at Harvard University in Cambridge, Massachusetts.
“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,” Rogoff said. He is co- author with Reinhart of the book “This Time is Different: Eight Centuries of Financial Folly,” which Federal Reserve Chairman Ben S. Bernanke has called “an extraordinary piece of work.”
Foreign central banks and other official institutions held 41.5 percent of outstanding marketable U.S. government securities as of June 30, 2010, according to the latest, most authoritative data available from the Treasury. If the Fed’s purchases are included, the proportion held in official hands jumps to about two-thirds.
Investors may be putting money into Treasuries because they see few alternatives, Mueller said. 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 said.
As the world’s largest economy with the most powerful military, the U.S. has advantages other countries don’t and often is seen as a haven for investment at times of uncertainty. That may be happening now. Fears about political instability in the Middle East and in parts of Europe might be spurring some Treasury purchases, said Daniel Fuss, vice chairman of Loomis Sayles & Co. in Boston.
The wake-up call for bond investors is often the disclosure of “hidden debt,” Reinhart said. That happened with Greece, when its budget deficit proved larger than projected, and the same could occur with the U.S., she said. “We have a lot of contingent liabilities.”
Standard & Poor’s flagged what it called the country’s “contingent fiscal risks” in revising its outlook April 18 on U.S. Treasury debt to negative. Among the hidden costs it cited were potential losses on government-guaranteed student loans and mortgages backed by the Federal Housing Administration.
The New York-based rating company also highlighted the coming squeeze on finances from the aging of America’s population. Medicare won’t have sufficient funds to pay full benefits starting in 2024, and Social Security’s cash to pay full benefits runs short in 2036, according to a U.S. government report last month.
The steepness of the yield curve may reflect some unease among investors about America’s longer-term prospects, Mueller said. The difference between two-year U.S. debt and 30-year Treasuries widened to the most in more than a month yesterday. The curve is one of the 10 components that make up the leading economic index, a gauge of the outlook for the next three to six months compiled by the New York-based Conference Board.
Fuss, who began his investment career in 1958 and is co- manager of the $21 billion Loomis Sayles Bond Fund, is betting the U.S. will try to deal with its debt problem by fostering faster inflation to reduce the real value of its liabilities.
“I think that’s the way it’s going to go,” said 77-year- old Fuss, who reduced the average maturity of the debt his fund holds to 9 1/2 years from 10 1/2 years at the end of 2010 to protect against higher inflation. “The question is, how unsettling, how rowdy does the bond market get in the process?”
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