New President Still May Answer to Bond Investors
For much of Bill Clinton’s presidency, he and his former Treasury Secretary, Robert Rubin, held one rule to be inviolable: Don’t upset the bond market.
The key to prosperity, Clinton was instructed by Rubin and others, was to placate the bond traders and portfolio managers who controlled long-term interest rates--and thus the cost of borrowing for government, consumers and many businesses.
In the early and mid-1990s, as the federal budget deficit soared, keeping the bond market happy meant promising long-term restraint in federal spending, and nodding approvingly as the inflation-paranoid Federal Reserve Board sharply tightened credit in 1994 to slow the economy.
Today, on the verge of an election that will put either Al Gore or George W. Bush in the White House for four years, the bond market must be feeling like a former wealthy relative no longer invited to discuss important family matters.
With federal budget surpluses stretching as far as the eye can see, the critical issue facing Washington is how to spend all those hundreds of billions of current and future dollars--rather than how to find bond buyers to finance the government.
In fact, if the surplus numbers are even close to being on target, the Treasury bond market as we know it is threatened with extinction. The lack of net new government borrowing, and plans to use much of the surplus to buy back existing bonds, could reduce the outstanding total of marketable federal debt (that is, what’s in private investors’ hands) from $3.5 trillion at midyear to under $800 billion as soon as 2006, according to Merrill Lynch & Co.
Tempting though it may be to believe that the bond market has become a political afterthought, however, it isn’t quite that simple.
The Treasury bond market may be shrinking dramatically, but the rest of the credit market--those investors and lenders worldwide who hold the bonds and loans of American companies and consumers--is bigger than ever, thanks to the borrowing binge of the last five years.
Whichever man takes the White House, therefore, will still have to be concerned with how his economic, spending and tax policies affect bond investors’ perceptions of future U.S. inflation and prosperity--because those perceptions will determine what the investors charge to continue extending private-sector credit.
In turn, what happens with corporate credit costs will naturally have a major impact on Wall Street’s view of stock prices. That is already an issue this year, as the shares of many troubled corporate borrowers have been hammered amid a slowing economy.
What’s more, the public may elect the president, but it doesn’t pick the governors of the Federal Reserve System. The Fed, under Chairman Alan Greenspan, is still in charge of setting short-term interest rates. And like private-sector lenders and investors, the Fed takes its cues largely from what it believes the inflation outlook to be.
Under either Gore or Bush, a too-hot economy fueled by new tax cuts and/or new spending initiatives could put the White House on a collision course with Greenspan and his cohorts.
Does the bond market, then, favor one candidate over the other?
The conventional wisdom this year has been that a Bush victory, in tandem with retained Republican control of Congress, would open the door to an onslaught of tax cuts that could be viewed as overly stimulative for the U.S. economy.
John Lonski, economist at Moody’s Investors Service in New York, believes that a Republican sweep on Tuesday “will almost certainly put upward pressure on Treasury yields” in the near term, as investors reconsider some of the assumptions that have help push long-term T-bond yields lower this year.
Key among those assumptions has been that the economy is slowing, and that Uncle Sam will continue to use much of the budget surplus to retire outstanding Treasury debt. The Treasury paid down $45 billion in debt in the third quarter and expects to pay down $23 billion in the current quarter.
From the financial markets’ perspective, the risk in Bush’s program is that the effects of his tax cuts, if enacted, could be felt much faster in the economy than the effects of Gore’s multiyear new-spending program.
Would tax cuts necessarily be inflationary? Perhaps not. But bond investors may initially demand higher interest rates to compensate for that risk, anyway. (Remember: The No. 1 enemy of bonds is rising inflation, because inflation erodes fixed-rate returns.)
A Gore victory, meanwhile, could be viewed favorably by the Treasury bond market in the near term because Gore’s tax cut plan is far smaller than Bush’s, and because Gore pays more lip service to paying off government debt entirely (by 2013, he says).
What the Treasury market might like most of all, however, is a Gore victory while Republicans keep both chambers of Congress, or at least one.
That would hold out the prospect of a paralyzed government. If Treasury coffers continue to overflow while nothing gets done inside the Beltway, that excess cash would automatically slash government borrowing further, and accelerate debt buybacks.
But Jay Mueller, economist at Strong Investments in Milwaukee, isn’t so sure the Treasury market would favor Gore over Bush. He points out that Gore’s spending program is larger than Bush’s, and says bond investors might be more spooked by the prospect of a return to the days of a free-spending federal government.
In any case, as noted earlier, the Treasury market is just one slice of the bond market, and a shrinking slice at that.
What is almost certain to be more important in coming years is what happens with corporate bond yields and rates on consumer debt. The total of U.S. corporate and consumer debt outstanding today exceeds $21 trillion--nearly seven times the amount of marketable federal debt still outstanding.
This year, while long-term Treasury bond yields have tumbled from their peaks early in the year, corporate bond yields have either risen (in the case of the riskiest bonds, such as “junk” issues) or have come down only modestly.
The worry in the corporate bond market has centered on the idea that the economy could slow too much--leaving many companies struggling to pay their debts.
In that context, a Bush victory, or Republican sweep, “wouldn’t necessarily be bad for the corporate bond market,” Mueller said: Investors could assume that Bush would be much friendlier to business, offering corporate tax cuts and potentially less regulation--all of which could bolster the outlook for corporate earnings growth and corporate credit-worthiness.
A Gore win, by contrast, conceivably could be worse for the corporate bond market if he stands for more regulation and a greater relative business tax burden.
All of this is hypothetical, of course. And understandably, few voters will be going to the polls Tuesday to cast their ballot based on what they expect to happen with interest rates.
Still, as marginalized as the bond market appears to be today, it’s worth remembering that it still sets long-term interest rates--and thus, if irritated enough, it can still make life miserable for politicians and the rest of us.
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Tom Petruno can be reached at tom.petruno@latimes.com.
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Debt: The New Mix
In the days of mushrooming federal deficits in the early 1990s, President Clinton’s policies were at the mercy of potential Treasury bond investors. Now, as federal debt sinks while private debt soars, the new president will have different borrowers to worry about.
2000: Federal debt $3.52 trillion
Note: Federal debt total is for marketable securities.
Source: Federal Reserve
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Bond Yields: Separate Tracks
Yields on corporate junk bonds--debt of higher-risk companies--have soared this year as investors have grown fearful about the companies’ ability to repay their debts. Meanwhile, yields on 10-year Treasury notes have sunk as the Treasury’s debt
buyback program has cut the supply of longer-term T-bonds.
Junk bonds
on Friday: 11.6%
10-year Treasury
note on Friday: 5.83%
Note: Junk bond yield is KPG index of 100 junk issues
Source: Bloomberg News
