Big bills racked up to buttress economic recovery are coming due
The global financial system avoided a potential train wreck as Greece’s government won a confidence vote in Parliament, the first step toward another European bailout of the debt-hobbled nation.
Yet even as stock markets rallied worldwide Tuesday, analysts warned of a summer that’s likely to be dominated by continuing investor jitters over government debt levels in Europe, the U.S. and Japan.
The central issue: Two years into the global economic rebound, big bills that governments and central banks racked up to buttress the recovery are coming due — figuratively if not literally.
Until now, a typical political maneuver has been to put off tough spending decisions in favor of more borrowing, a strategy of “kicking the can down the road,” as Wall Street often calls it.
But “we are coming to the end of the road,” said Mohamed El-Erian, chief executive of money management giant Pimco in Newport Beach.
In Europe, investors either are balking at extending more credit to struggling governments or they’re demanding such high interest rates on loans that Greece, Ireland and Portugal all have had to turn to the rest of the continent for bailouts — in Greece’s case, twice in the last 12 months.
In the U.S., Republican leaders are threatening to block an increase in the federal debt limit, and risk defaulting on the Treasury’s debts by early August, unless the White House agrees to massive spending cuts.
The Federal Reserve, which since November has tried to bolster the economy by pumping an additional $600 billion into the financial system via purchases of Treasury bonds, on Wednesday is expected to affirm that it will finish that stimulus program June 30 as planned. Chairman Ben S. Bernanke will hold a news conference after the Fed concludes its first meeting of the summer.
The central bank’s critics say the Fed already has gone too far in boosting its Treasury and mortgage bond portfolio to a stunning $2.6 trillion since the financial crisis began in 2008, an effort to hold long-term interest rates down and underpin the recovery.
That has left the Fed with a “bloated” balance sheet that could come back to bite policymakers, said David Kelly, chief market strategist at JPMorgan Funds in New York. At the same time, he questioned what the Fed has achieved with its unprecedented bond purchases.
Despite a drop in average U.S. mortgage rates to 4.5%, the lowest since early December, the housing market remains moribund. Bernanke’s stimulus program “didn’t promote more spending in interest-rate-sensitive sectors of the economy,” an obvious goal, Kelly said.
With the economy weakening this spring, led by housing, fear of a deeper slowdown has dragged stock prices lower since late April. But global equity markets rebounded sharply Tuesday as some investors bet that the Greek Parliament would back Prime Minister George Papandreou in a confidence vote. Papandreou, who is seeking a new round of financial help from the rest of the euro-zone, won the vote in a late-night session. The announcement came after U.S. markets closed for the day.
The Dow Jones industrial average rose for a fourth straight day, rallying 109.63 points, or 0.9%, to 12,190.01. Broader market indexes posted stronger gains. In Europe, the Greek stock market advanced 3.7%, German shares rallied 1.9% and the Italian market rose 2.1%.
Wall Street’s improving mood will be tested Wednesday after the Fed meets. Although policymakers are virtually certain to call an end to their bond-buying, analysts say the Fed also will reiterate its intent to continue holding short-term interest rates near zero indefinitely to support the recovery.
As with the Fed’s bond purchases in the U.S., the European Central Bank also has gone out on a limb for Greece, Portugal and Ireland, buying the countries’ bonds in the open market over the last year to try to suppress interest rates.
But that hasn’t stopped yields on bonds of Europe’s weakest economies from rocketing as private investors have fled the markets. Greece faces 28% annualized borrowing rates on its two-year bonds. Ireland’s two-year bond yields have shot to nearly 13%.
By contrast, the U.S. Treasury pays a mere 0.37% on two-year debt. U.S. bond yields have continued to slide as investors have sought relative safety, despite the GOP threat on the debt limit.
Shut out of the bond market, Greece is seeking as much as $158 billion more from other euro-zone countries to continue paying its debts while trying to revive economic growth.
Yet many analysts say Europe’s leaders are fighting a losing battle trying to keep Greece afloat.
“It increasingly looks like good money is being thrown after bad,” said Michael Woolfolk, a currency strategist at Bank of New York Mellon.
That also is the view of a group of German lawmakers that has been pushing the Berlin government to demand that private Greek bondholders share in the pain of another bailout. The group essentially wants Greece to default by demanding that bondholders exchange current debt for new bonds that pay less.
The default option has been rejected by the European Central Bank and by German Chancellor Angela Merkel, however. In part, the ECB is looking out for its own finances: A default would further depress the value of Greek bonds on the ECB’s books and could also slam the bonds of other struggling states, especially Portugal, Ireland and Spain.
Investors’ worst fear is that a Greek blow-up would spread through the financial system worldwide, as the collapse of Lehman Bros. did in September 2008.
Although U.S. banks hold few bonds of Europe’s weakest countries, many money market mutual funds invest in short-term paper of Europe’s biggest banks, all of which could be shaken by a Greek meltdown because of intertwined finances. Fitch Ratings on Tuesday calculated that U.S. money funds had 50% of their assets in debt or certificates of deposit of European banks.
Near-term, Tuesday’s vote by the Greek Parliament may help boost confidence that Greece can avoid default. But the bigger test will come by July 3, the deadline that European authorities have given Greece to agree to harsh new austerity measures before another bailout can be negotiated.
Pimco’s El-Erian believes that some portion of Greece’s nearly $500 billion in government debt ultimately must be forgiven because the burden has become crushing. More spending cuts will merely deepen the country’s the recession.
Greece “may be able to buy six more months, but even that is doubtful,” he said. “Europe has nothing but bad choices at this point.”
Some experts see a parallel in the U.S. housing market. Banks have been unwilling to agree to extensive debt forgiveness for homeowners whose properties are worth less than their mortgage. But the market has only gotten worse this year as prices have continued to fall and buyers remain scarce.
“The U.S. housing situation is analogous to what’s happening in Europe, absolutely,” said Andrew Busch, public policy strategist at BMO Capital Markets in Chicago.