United States Treasury Bonds have been considered the safest investments in the world for the greater part of the past century. They are universally liked by foreign governments, sovereign wealth funds, pension funds, all the way down to the average investor. Backed by the implicit full faith and credit of the US Government, the status of Treasuries as a safe investment was highlighted most comprehensively by the swelling demand for them during the nadir of the financial crisis. In September-November 2008, public and private investors wanted nothing but the safest paper, and the flight-to-quality that began late that summer resulted in the greatest short-term rally that Treasuries have ever seen. Consequently, those prices came back down to earth in 2009. However, as the deficits continue to pile up, and hundreds of billions in unfunded liabilities continue to smolder, there has rightfully been speculation with regard to the full faith and credit of the US Government.
Two hypothetical scenarios have emerged in recent months. The first is the possibility that China, the largest purchaser of Treasuries, will scale back on such purchases, causing yields to rise. The other theme of recent speculation, as mentioned by PIMCO’s Bill Gross in a recent fixed-income outlook, is whether corporate bonds are potentially a better investment than US Government bonds.
In late 2009, US Treasury department data revealed that China was no longer the largest holder of US Treasury Bonds. However, two weeks ago revised numbers were released showing that China was still the largest buyer, holding $894.8 Billion of Treasuries. Nevertheless, this number is down from its mid-2009 peak of over $900 billion, as China reduced its holdings of US Treasuries by about $45 billion. While it is too early to determine whether this is a permanent trend, it represents a definite stall in the rise of US debt owned by the Chinese, which had been rising for the last decade (refer to Chart 1).
Chart 1 – China’s Holdings of US Treasury Bonds 2000-2009
A recent guest on Bloomberg Radio speculated that an impending disaster would occur if China were to scale back its purchases of Treasuries to the level of a decade ago. Yes, of course that would be a disaster, but it is not likely unless China’s economy completely and utterly collapses. According to the World Bank, China's GDP more than tripled from $1.2 trillion in 2000 to $4.33 trillion in 2008. With continuing diversification, it is reasonable to say that if China scaled back on its purchases of Treasuries, it could return to 2006-07 levels, but even that would represent a 40-50% retracement, which is unlikely. The Chinese need safe investments to protect their ever-increasing wealth, especially with the current economic uncertainty within their own borders.
In China, there is currently a real estate bubble for which its government is attempting to engineer a soft landing. One of the measures undertaken is the raising of reserve requirements to prepare Chinese banks for the hit they may take. When the bubble inevitably pops and the Chinese demand safe investments, it is likely that their appetite for US Treasuries will at least be sustained. With yields on longer-dated US Treasuries already rising, this appears even more likely. Therefore, while I do not see the Chinese selling off Treasuries on any sizable scale, a steep Chinese recession could sap demand and cause yields to rise, contributing to inflation.
Furthermore, as government deficits around the world increase, we are potentially entering an era where the paper of selected corporations appears safer than selected nations’ sovereign debt. This was not the case previously and is still generally not. However, there is an emerging debate among fixed-income commentators about whether the highest-rated corporations could consistently trade at yields below that of their home country’s debt. Bond guru Bill Gross (CEO of PIMCO) recently commented on the current fixed-income landscape in his March 2010 investment outlook. He stated that “the narrowing in spreads since late November solicits an interesting proposition: government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous ‘unicredit’ type of bond market. If core sovereigns such as the US, Germany, UK, and Japan ‘absorb’ more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee.”
This poses the question of whether the numerous sovereign debt crises that have been sprouting up can be truly resolved by issuing more debt. The answer depends on the initial debt levels of the economies in question. The more indebted the nation, the more spreads will narrow for that country’s paper if their policymakers are successful in their efforts. Gross further stated, “When sovereign issues become more credit-like, as evidenced in Greece, Spain, Portugal, and a host of others, they move closer in yield to the corporate and agency debt that supposedly rank lower in the hierarchy.” Therefore, the answer depends on the combination of future inflation, the result of quantitative easing programs, and the recoveries of individual economies. More importantly, going forward sovereign debt investors will be on the lookout. Those economies that continue to bail out their institutions and fail to incorporate fiscal discipline will be more closely scrutinized. Finally, if the world economy relapses into recession from its current fragile state, it will be interesting to see what the appetite will be for Treasuries, PIIGS Bonds, UK Gilts, etc. No disrespect to Sinatra, but love may not always be lovelier the second time around.
With regard to China, in my opinion there is no such thing as an economic “soft landing.” Alan Greenspan was initially commended for having supposedly engineered such a scenario for the US economy in 2001-02. That praise waned with the onset of the financial crisis. He said in a 2009 interview that “September 11 was the type of event that historically could result in the undoing of a nation.” With the nation in shock, plus an economy already reeling from the bursting of the technology bubble, Greenspan began a series of sharp interest rate cuts to spur activity. While this fueled the housing boom and assisted the subsequent five –year bull market, the increased private debt that it encouraged (personal and corporate) ultimately made the 2008 fallout much worse than it otherwise would have been. I am not saying that it would not have happened, but in hindsight I think most would agree that a sharp 1-2 year recession, perhaps ending in 2003, rather than a mild nine-month recession would have been okay if it had prevented the housing bubble from growing out of hand which, as we know, is the root of the economic malaise of the past three years.
If the debt situation becomes unmanageable, my sense is that our leaders will first resort to raising taxes. When the ability to raise taxes fails, inflation will be the solution. It will need to be controlled, however. It could easily get out of hand, and when the political outcry becomes too great, then maybe, just maybe, our leaders will finally cut entitlement spending. This, however, is always an option of last resort because of the negative consequences for those in office. Furthermore, external default would not be enough to solve the problems the US faces, besides the fact that it would strain economic relations with the rest of the world. In a worst case scenario, US assets could potentially be seized by foreign governments, along with many financial institutions failing in the US and abroad. China can’t stop buying our debt because that would force the US to cut spending immediately, perhaps causing a recession in which the US consumer will stop buying Chinese products, and the economic interdependency would manifest itself in the worst way. There are no easy answers. The pain has to go somewhere, and because times were so good for so long we were able to delay the problem. It has only had the effect of building up the eventual pain that will need to be felt.
Respectfully Yours,
Matthew R. Green
March 5, 2010
