Europe’s mess gives U.S. a reprieve on debt comeuppance
It’s wrong to take comfort in the suffering of others.
But for millions of Americans who’ve sought refuge in bond investments since 2008, it’s hard not to be appreciative of Europe’s grinding financial crisis.
The threat of a meltdown across the Atlantic has kept money pouring into high-quality U.S. bonds, particularly Treasury issues, as a haven. That has held interest rates near generational lows since early August, in turn boosting the value of older bonds issued at higher rates.
Much of Europe, meanwhile, has faced just the opposite situation: Government bond yields have surged — most recently in Italy — as global investors continue to fear that the ultimate solution to the continent’s debt debacle will be widespread defaults.
Yet many Americans also sense that Europe’s woes are a warning. As total U.S. Treasury debt outstanding has mushroomed to nearly $15 trillion now from $10.6 trillion three years ago, a day of reckoning must be out there for Washington too.
Get ready to hear more of the same soon: The congressional “super committee” created last summer to identify federal spending cuts has until Nov. 23 to agree on how to reduce U.S. budget deficits by at least $1.5 trillion over the next decade.
Failure to slash at least $1.2 trillion would trigger mandatory cuts of that amount beginning in 2013.
More important, if the committee drops the ball, it risks another downgrade of the nation’s credit rating — a chilling thought, given the mayhem in financial markets after Standard & Poor’s cut the U.S. rating to AA+ on Aug. 5, the first-ever decline from the gilded AAA level.
S&P said the move was warranted in part because of the speed with which the nation’s debt level was rising. The ratings company has continued to say that Congress should reduce the deficits by a minimum of $4 trillion over the next 10 years, more than twice the super committee’s mandated target.
S&P’s main rival, Moody’s Investors Service, still rates the U.S. Aaa. But Moody’s has a negative outlook on its rating, meaning that a cut is possible. Even so, Moody’s said earlier this month that the success or failure of the super committee wouldn’t by itself be a “decisive” factor in whether the U.S. retains the Aaa grade.
For now, it appears that neither S&P nor Moody’s is poised to react quickly even if partisan politics keep Democrats and Republicans on the super committee from agreeing on serious budget cuts.
There’s another possibility: The lack of a credible deficit-reduction plan could drive investors to render their own downgrade of U.S. debt by suddenly demanding higher interest rates on Treasury bonds.
What if the market decided that the current 2.06% yield on 10-year T-notes was ridiculously low? How about just taking it back to 4%, its level in April 2010? That might deliver a far stronger message than S&P and Moody’s ever could about the need for more fiscal discipline in Washington.
But as much as many people might wish for the market to send that dunning notice to Congress, don’t count on it. There are powerful forces aligned that likely will keep U.S. interest rates depressed for the near future, which of course would be good news for bond owners (and for that matter, stock investors as well).
For starters, Europe’s 2-year-old debt crisis shows no sign of being contained. The continent’s leaders are still trying to save Greece, while the crisis now has engulfed Italy — the Eurozone’s third-largest economy and world’s third-largest bond market, with $2.6 trillion in sovereign debt.
Increasingly nervous about Italy’s ability to pay its debts in the long run, investors pushed the market yield on 10-year Italian government bonds to a 14-year high of 7.25% on Wednesday. The yield pulled back to 6.45% by Friday, but that still was up from a week earlier.
The higher Italy’s borrowing costs go, the greater the risk that default becomes inevitable. That’s exactly what happened with Greece.
What’s more, Germany and France have been talking openly about the idea of the Eurozone’s weakest countries leaving the currency union and basically fending for themselves. That’s not a way to inspire confidence.
So for big-money global investors looking for a relatively safe bond investment, U.S. debt has no real competition from the Eurozone other than Germany, said Carl Lantz, interest rate strategist at Credit Suisse Securities in New York.
The world also knows the Federal Reserve’s views on U.S. long-term interest rates: It wants them lower, or at least not higher.
The Fed said in September that it would shift $400 billion of its Treasury bond holdings from shorter-term securities to longer-term issues by mid-2012, hoping to keep rates suppressed by providing a constant source of demand for longer-term debt.
“What the Fed wants to do is crush real [after-inflation] interest rates,” said Bill O’Donnell, chief government bond strategist at RBS Securities in Stamford, Conn.
Of course, the Fed can’t force the market to do its will with long-term rates. When the Treasury sold $24 billion worth of 10-year notes on Wednesday and $16 billion worth of 30-year bonds on Thursday, demand wasn’t particularly robust.
Investors have pushed the 10-year T-note yield up more than 0.3 of a point from its 60-year low of 1.72% in late September. A temporary move up to 2.5% wouldn’t shock Wall Street.
But the Fed clearly wants to be an anchor on bond yields, and Chairman Ben S. Bernanke has left no doubt that policymakers could throw more money at the bond market if they thought the economy needed more help on rates.
That brings us to what is usually the main driving force behind interest-rate moves, up or down: expectations for the pace of economic growth.
The U.S. economy has defied predictions that it would fall back into recession. Gross domestic product rose at a 2.5% annualized rate in the third quarter, nearly double the second-quarter rate. But this is an economy that continues to face so many head winds — including high consumer debt, high unemployment, and state and local government austerity — almost no one believes that a breakout to sustained fast growth can happen soon.
Bernanke said last week that U.S. growth was “likely to be frustratingly slow.” An economy that muddles along probably isn’t going to scare investors out of bonds.
Something else could: a further jump in inflation.
Pushed up by higher food and energy costs, the Consumer Price Index was up 3.9% in September from a year earlier, the fastest rate of inflation in three years. That means a 2% bond yield is a money-loser right now, after inflation.
The Fed keeps saying that inflation will moderate. Bond investors seem to be buying that story.
Is this all just a case of mass delusion? The best reason to believe that U.S. bond yields can’t stay this low for much longer is that so many people are on that side of the boat.
But if money were to exit high-quality U.S. bonds en masse, it would have to go somewhere else. With Europe a mess, stock market volatility off the charts and cash paying nothing, for now many bond investors see their alternatives as severely limited.
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