The bond market usually starts to worry about unsustainable government finances long before politicians and policymakers do. Not this time.
Deficits and the debt have moved to the centre-stage of the US political debate, shaping the fight over healthcare reform and constraining further initiatives to support growth.
With Republicans seeking to tar Democrats as responsible for record borrowing, and foreign officials citing the US fiscal outlook as an underlying cause of dollar weakness, top administration officials are vowing to put public finances back on a sustainable path starting with next year’s budget.
Yet all this is taking place at a time when the bond market is calm. Yields on 10-year Treasuries closed Friday at 3.49 per cent – very low historically, in spite of a sharp deterioration in public finances since the start of the crisis and the recent revival in appetite for riskier assets.
In the fiscal year to September 30 the US ran a record deficit of $1,400bn (€932bn, £859bn) – 10 per cent of gross domestic product – issuing a record $7,000bn in gross debt and $1,700bn in net debt. The independent Congressional Budget Office projects
medium-term structural deficits above 3 per cent of GDP, with the debt to GDP ratio rising from 41 per cent in 2008 to 66 per cent by 2012, then drifting higher.
However, while a top analyst at Moody’s, the credit ratings agency, told Reuters last week that the US’s triple-A rating “is not guaranteed”, most investors find the idea of a US default (or even a backdoor default via high inflation) implausible.
Karthik Ramanathan, acting assistant secretary for financial markets at the US Treasury, said: “We are issuing a significant amount of debt, but we are doing so in a very predictable, transparent and regular manner. Investors are realising that fiscal year 2009 was the peak year in terms of net issuance.”
The rise in household savings has increased the pool of available domestic funds, while net private debt issuance has shrivelled, with virtually no supply of triple-A rated structured credit products.
Moreover, while foreign official reserve managers are increasingly uneasy at their accumulated exposure to US assets, there is also renewed appreciation of the liquidity of US government securities.
Mr Ramanathan said: “In the midst of the crisis …the Treasury market was one of the only markets which continuously functioned and in which trades were occurring.”
New liquidity regulations for banks and for money market funds are also likely to shift demand towards liquid government paper.
Lou Crandall, an economist at Wrightson Icap, said investor valuation models further anchor rates.
Still, some worry Treasury yields could back up when the Federal Reserve stops buying securities and/or signals it is close to raising rates.
Although the Fed set out to buy only $300bn of Treasuries, it targeted $1,450bn of closely related securities issued by Fannie Mae and Freddie Mac.
Even if there is no abrupt back-up in rates, the calm in the bond market does not mean the US government can keep on borrowing without limit. The risk of crowding out private activity – low today – will mount as the economy recovers. Even with low yields, the US paid out $190bn in interest on its debt last year – much more given debt notionally held in trust funds for programmes such as Social Security.
Given the cost of a bond market revolt, the case for acting before the market loses patience is strong.
Indeed, the market may be calm in part precisely because the political winds have now turned in favour of debt reduction. The bond market could react badly if fiscal discipline around healthcare reform collapses.
Analysts said next year’s budget – already subject of intense discussion among policymakers – will be a key reality check for investors.
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