Clem Sunter

Will American treasuries become junk bonds?

2010-12-15 12:30

Suppose you are a retailer. You have been losing money but you decide to continue to discount your prices in the hope that demand will pick up. It’s a bit of a gamble, isn’t it? If you add into the equation that you are up to your ears in debt already, it increases the risk.

Such is the case with the US government – or more specifically President Obama, when he announced that the tax cuts across all income groups in America would continue. At the moment, the US budget deficit is running at around 10% of GDP and national debt is heading towards 100% of GDP. In simple terms, government expenditure is outstripping government revenue and, unlike in the UK, no attempt has been made to cut expenditure. The losses will be financed by further borrowings.

In a sense you can let Obama off the hook because it was his predecessor, George W Bush, who instigated the tax cuts in the first place. Obama inherited an appalling financial position from Bush, partially due to the ‘great recession’ and partially due to the fact that Republicans – despite their conservatism – are fiscally more irresponsible than Democrats. The last person to have a balanced budget in the US was Bill Clinton.

Now I know that some of you will say that a government is not a business because a government can print money unlike a business. Moreover it can issue bonds which carry a much lower risk rating than the private sector paper. Indeed, all the major ratings agencies give a Triple A rating to US bonds. So, as a government you can play games which are beyond the capability of companies listed on the stock exchange.

And play games they have, firstly issuing more treasury bills to raise more money and then getting the Federal Reserve Bank to buy them back to keep interest rates down while injecting new funds into the market. QEII – the second round of quantitative easing – will add $600bn to the money supply.

However, a funny thing happened on Wall Street last week which suggests that all is not going the way of the US government. When President Obama announced that the tax cuts would continue across the board, the US government ten-year bond rate immediately jumped. This would imply that some investors are getting jittery about holding these bills at such a low rate of interest. They sold the bonds which drove the price down which pushed interest rates up.

It wasn’t a major incident and indeed the price of the US ten-year bond has to a certain extent recovered. But it does not need much of a movement in the interest rate upwards to cause a lot of problems in central banks around the world, which are stuffed full of US treasury bills as the safest paper around. The bond price is the reciprocal of the current interest rate. Hence if the interest rate were to rise from 2.5% to 4%, the price of the bond would fall by around 12%.

The question is whether central banks have to mark to market any losses on their investment holdings as commercial banks are compelled to do. If so, we could be in for some nasty surprises – particularly if the dollar has also devalued against the country’s domestic currency. In a sense this would be the central banks’ equivalent of the sub-prime mortgage fiasco except obviously the bonds would not lose quite so much value. But the losses could still be spectacular.

One must never forget that markets are built on trust and confidence. If these factors go out of the window because you are viewed to have taken irresponsible risks in the way you have structured your finances, it does not matter how big you are or that the dollar is a reserve currency. People will run a mile.

A key flag for a short-term double-dip in the markets is therefore the US ten-year bond yield. Providing it stays below 4%, everything is manageable. Should it breach that barrier and head further up, watch out!

Consequently, whenever I am watching CNBC Africa or Bloomberg, I go to the moving ticker at the bottom of the screen to check out the latest ten-year rate. That is what a foxy futurist does. It’s currently 3.34%.

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