At this stage of the economy's recovery process, the US can ill afford a further sell-off in treasury prices.
In the last few weeks we have seen a significant and sustained rise in the most important interest rate in the world. On single days over the past few weeks the yields on the 10-year US treasury bond have moved by over 15 basis points, a highly unusual event. With the yield now at 3.9 per cent, the move has been over a 100 basis points this month alone. Yields are now higher than before the whole quantitative easing policy was announced. This type of upwards move in rates has occurred despite the Fed funds rate at effectively 0 per cent, and the Fed buying securities directly in the markets. So what is going on? Should investors and policymakers care? What are the implications for longer-term growth?
First of all, the markets are finally understanding the reality that the US may be stuck with trillion dollar deficits for some time. The combination of the fiscal stimulus plan, funding multiple bail-outs and weak tax revenues, has thrown the US budget seriously out of balance. The US is expected to have a deficit of over $1.5 trillion or 10 per cent of GDP this year, and while everyone including Obama believes that this is unsustainable, it is not clear how this number can be brought down in a meaningful fashion without large tax increases, which in turn will damage long-term growth rates. If you assume that the US is unlikely to grow at more than 1-2 per cent (over the next two-three years), and given Obama’s desire to universalise healthcare, significant tax increases are the only way forward in the US.
The current $1.5 trillion deficit does not even address the huge upcoming liabilities for social security, Medicare and Medicaid. As the baby boomer generation in the US retires, these liabilities will crystallise. Private thinktanks have estimated that spending on these three items will have to increase by about 6 per cent of GDP over the next 20 years, leading to even larger deficits, or alternatively higher taxes. Collectively these three programmes represent a $40 trillion liability for the US government and, if not paid for, will have to be added to the current debt load of $10 trillion.
The added issue weighing on the markets is who will buy all these new bonds? Market experts expect about $3 trillion of new treasury issuance on a gross basis and about $2 trillion of net issuance in 2009. This is four times the number for 2008.
Prior to this year, the recycling of the US trade deficit/current account created enough natural demand for treasuries to fully absorb all new issuance. Now with this amount only about $500 billion, it is obvious that even if they wanted to, the Chinese and other surplus nations cannot absorb the quantum of planned issuance. Who will absorb the incremental $1.5 trillion? The US banks and retail investors will have to step up, but can they continue absorbing this quantum of paper on an annual basis? What will this do to private sector borrowing costs?
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The concern is that in the long term this absorption of paper can only happen in two ways. One is for bond yields to rise in a sustained and structural fashion, and the second is for the Fed to remain involved in the markets as the buyer of last resort. While rising bond yields are negative for growth and equity valuations, the continued use of the Fed’s balance sheet to absorb treasury paper will risk long-term inflationary consequences and dollar weakness. Make no mistake, the US has some tough choices ahead.
Markets have also begun to understand that it will not be easy for the US authorities to drain out the huge amounts of emergency liquidity that has been pushed into the system. It is always difficult to know when to reverse course, and given the unprecedented nature of the current policy support, the consequences of a course reversal are even more unclear. Once a system has got used to life support, how do you cut off the oxygen? Can the markets, banking system and the real economy thrive today independent of Fed support? It is going to be a very delicate balancing act to withdraw Fed support, with risks of a renewed down-leg in markets and the economy. The much-feared W-shaped recession is a real concern if withdrawal of emergency support facilities is not handled delicately. Given the risks associated with an early withdrawal of emergency support, there is a real risk that the Fed will overstay with the attendant consequences on inflationary expectations.
The markets have also been spooked in part by S&P’s announcement earlier this month that put the UK’s AAA rating on negative outlook. Given the many similarities between the economic outlook and issues facing the US and UK, this was a reminder that sovereign risk in the US could also one day come into question. More than just a US issue, this is a worry more for all the Asian central banks holding trillions of dollars worth of US paper. Though a remote possibility today, it may eventually raise risk premiums on US paper.
There is an argument that all one is seeing is more a normalisation of bond yields rather than anything more sinister. Bond yields always rise in economic recoveries without causing W-shaped recessions. As per this chain of thought, stronger economic prospects push treasury yields higher, but also cause a narrowing of credit spreads, thus protecting the real economy from any interest rate shock. While there is some element of truth to this line of thought and it may partly explain the rise in yields, I think the markets are more focussed on the longer-term structural issues outlined above.
The treasury bond sell-off is now putting pressure on other parts of the US economy. The biggest worry should be in housing where borrowing rates are beginning to rise independent of Fed mortgage buying. Housing is central to the recovery and stabilisation of the US and no sustained economic recovery is possible without house prices stabilising. Rising oil prices have further complicated the situation. There is no way the US consumer today can withstand simultaneously higher fuel prices and interest rates.
At this stage of the economy’s recovery process, the US can ill afford a further sell-off in treasury prices. In order to cap yields one is likely to see the Fed more active in buying up mortgages and treasuries and for longer than the market currently anticipates.
The green shoots may themselves sow the seeds of the economy’s relapse. As more people buy into a recovery scenario, we are seeing yields, oil prices etc all normalise and increase. This process of normalisation is itself making the risks of a relapse greater.