Greece’s lesson for the U.S.: When bond investors turn on you, it’s over
For everyone who believes that America’s gargantuan federal budget deficits have us barreling down the road to ruin, there would seem no better supporting evidence than Europe’s government debt crisis.
After living far beyond its means for years, Greece’s day of reckoning arrived this week. “No more,” said bond investors, who suddenly demanded sky-high interest rates on Greek debt, in effect making it impossible for the Athens government to borrow another euro.
Market rates also surged on bonds of other heavily indebted European states, including Portugal, Spain and Ireland.
But the reaction in U.S. financial markets wasn’t what our own deficit hawks might have hoped. Instead of rising out of fear that Europe may be foreshadowing America’s not-too-distant fate, interest rates on Treasury bonds fell for the week.
That was convenient, given that Uncle Sam happened to be auctioning $129 billion in new debt from Monday through Thursday.
The two-year Treasury note yield ended Friday at 0.96%, down from 1.07% a week ago. The comparable yield on Greece’s two-year notes: a stunning 12.72%.
If you were hoping for some act of man or God to impose fiscal discipline on Washington, Europe’s current mess apparently isn’t going to be it. Money has to go somewhere, and investors demonstrated this week that enough of them still regard U.S. Treasury securities as a favored hiding place for cash in times of market turmoil.
While Greece’s loss was the Treasury market’s gain, the action in other world markets shows that many investors are trying to figure out just how much they should care about European debt woes, if at all.
Outside Europe, there is no spreading fire in bond markets in general, unlike during the collapse of credit markets in 2008. Back then, investors fled all assets perceived to carry even slight risk, including U.S. high-quality corporate bonds.
This time, the U.S. corporate bond market has been essentially fenced off from worries about debt-laden European governments’ ability to pay their creditors, notes Jim Swanson, chief investment strategist at MFS Investment Management in Boston.
That makes sense, for now: With the U.S. economy’s rebound and the dive in interest rates last year, major American companies’ finances have improved dramatically. Many are loaded with cash. Their credit is golden.
“We’ve witnessed a lowering of risk on the corporate side,” Swanson said.
That’s the polar opposite of what has happened with national governments that have packed on debt to fund economic bailout programs.
Investors also remain enamored of tax-free municipal bonds, despite valid concerns about the finances of many state and local governments. The share price of the Vanguard California Intermediate-Term Tax-Exempt mutual fund has appreciated 1.2% over the last month to the highest level since October, as investors have bid up the value of many muni issues (in turn pushing bond yields lower).
As for the U.S. stock market, Europe may have provided the excuse investors and traders wanted to take some money off the table after share prices hit 19-month highs a week ago. The Dow Jones industrial average finished Friday at 11,008.61, down 1.8% for the five days. The average New York Stock Exchange issue lost 2.9% for the week.
Still, robust first-quarter earnings reports from many companies have underpinned faith in the economic recovery.
Not surprisingly, Europe’s equity markets took a hit this week as investors were left to wonder about that economy’s next turn. Spanish stocks lost 3.9%. Germany, which doesn’t have the debt problems of its southern neighbors but which now is expected to lead bailout arrangements, saw its stocks drop 2%.
The severity of Greece’s debt load began to register with investors last fall as the country’s budget deficit ballooned while its economy shrank. By February markets were seriously questioning Greece’s ability to meet principal and interest payments on its $390 billion in public debt, equal to more than 100% of the nation’s gross domestic product.
The Greek economy is small — just 3% of the total GDP of the 16 euro-zone countries. However, Mohamed El-Erian, chief executive of bond giant Pimco in Newport Beach, sees parallels between Europe’s lack of urgency in dealing with Greece early on and the U.S. government’s initially muted response to rising defaults in the subprime mortgage market in 2007.
“The thinking is, ‘It’s small in size, it’s isolated and containable,’ ” El-Erian said.
With European authorities still dickering early this week about the details of a formal bailout plan for Greece, fear that the country was stumbling toward a debt default finally caused the Greek bond market to crack. It didn’t help that credit rater Standard & Poor’s slashed Greece to junk status Tuesday.
Far worse was that “contagion” set in, as investors began to dump Portuguese and Spanish government bonds, driving yields sharply higher, on concern that they too might be at risk of defaulting on their debt without financial aid from the rest of Europe.
But by Thursday, fear was receding. On Friday, as European policymakers and the International Monetary Fund pledged that a $160-billion aid package for Greece was imminent, yields continued to pull back on Greek, Portuguese and Spanish debt.
El-Erian, though, says Pimco isn’t tempted by the still-elevated interest rates on those countries’ bonds. He believes that too many investors who own that debt have been caught flat-footed, and may try to sell on any rally. And if yields spike again, the effect could be to make new borrowing prohibitively expensive for Portugal and Spain, necessitating bailouts for them as well.
“We think that, right now, you want to be on the sidelines,” El-Erian said.
He also worries about the potential fallout on Europe’s banks, which own massive amounts of European sovereign debt. The biggest risk of all, El-Erian said, is that debt-default concerns could cause depositors to lose faith in the banks because they lose faith in the governments that ultimately back the banks.
Pimco also has been perhaps the most vocal major investor warning about the risk of owning long-term U.S. Treasury securities given the ballooning federal debt — now $12.8 trillion, including what’s held by Social Security.
Still, the U.S. isn’t likely to face any time soon the kind of investor smackdown dealt to Greece, Portugal and Spain, El-Erian conceded. As the planet’s biggest economy and the provider of the world’s reserve currency, America has enormous financial flexibility obviously far beyond that of most smaller economies.
“The U.S. has more time” to get its fiscal affairs in order, El-Erian said.
But as Europe has shown, investors’ attitude toward a country’s debt can turn very quickly. And once it turns the mood can feed on itself.
Nouriel Roubini, the New York University economist who foresaw the global credit meltdown of 2008, said at the Milken Institute Global Conference in Beverly Hills this week that unless Washington gets serious about slashing its deficit, a Greek-style revolt by bond investors could happen sooner than markets might want to believe.
“The risk of something serious happening in the U.S. in the next two or three years is going to be significant,” he said.
