LIKE London buses, big events in America’s Treasury market all seem to come at once. In a week when the Treasury auctioned more than $100 billion of notes and bonds, ten-year Treasury yields surged to their highest level in six months, despite a buy-back offer by the Federal Reserve. That will raise the cost of finance for companies and homeowners.
All this activity was inevitable once the authorities decided to combine a huge fiscal deficit with quantitative easing (expansion of the money supply). It has been accompanied by a sharp rise in the gap between short and long rates. The ten-year yield has risen from 2.08% on December 18th to 3.70% on May 27th.
Some of that rise in yields is undoubtedly due to investors switching back into shares on hopes that the global recession might end next year. But there have also been concerns about America’s long-term financial health. On May 27th Moody’s said it had no plans to reduce America’s coveted AAA debt rating. But on the same day John Taylor, a professor at Stanford University and the creator of the Taylor rule on monetary policy, wrote in the Financial Times that the American government “is now the most serious source of systemic risk.”
With interest rates rising its clear Taylor is not just being a fear monger. Although the US is on track for a debt to GDP ratio of 80% by 2015, we are still in better shape then countries like Japan or Italy. This is important because a true fiscal collapse would lead to money being parked somewhere other then T-Bills or the US Dollar. As of now despite an occasional rumbling about China and an increase of Gold prices, a viable alternative to the United States is not around. The most likeley scenario, an increase of inflation as the US currency declines:
History is full of examples of sovereign nations failing to pay their overseas creditors in full. When push comes to shove, governments are unwilling to impose the required level of austerity on their voters. This happened in the 1920s Weimar Republic, which opted for hyperinflation rather than paying the reparations bill, and in 1930s Britain, which abandoned the gold standard in the face of the Depression. (Note the results of the recent referendums in California, where voters rejected all budget-balancing proposals.)
In countries that are frequent offenders, including those in Latin America, foreign creditors have in the past demanded that government debt be denominated in a foreign currency. America has been able to borrow in dollars. However, for foreign investors, that means Treasury bonds are not risk-free at all.Even domestic investors might reflect on the potential for inflation to erode the real value of their holdings. Inflation-adjusted, the capital value of Treasury bonds fell by more than five-sixths between 1962 and 1981.
Inflation-linked government bonds ought thus to be a more appropriate risk-free asset than conventional bonds. Foreign investors might calculate that, over the long run, a dollar decline would be matched by higher inflation, for which they would be compensated. However, the index-linked market is a lot less liquid than that for conventional debt. And cynics might wonder whether governments will really meet their obligations when faced with runaway inflation, rather than finding a way to “redefine” the statistics.
Of course inflation is a disaster in its own right, but compared to a full default by the US government the lesser of two extraordinary evils.