Given the debt accumulations projections from Sovereign Risk Part 2 it raises the question of why is it possible that the market is willing to accumulating Treasuries on such favorable terms. As a value proposition Treasuries and the US dollar must be considered to be in a price bubble with short term yields as low as 10 basis points. How can the two be reconciled when the future financing difficulties of the government are so well known and admitted to by The Economic Report of the President, the CBO study and Moody’s conclusion regarding the Treasury rating?
There is a reasonably long list of reasons why Treasuries continue to appeal to the market and much of it does not have to do with the value proposition of the Treasury as an investment. Treasuries as an asset class satisfy a number of objectives and constraints for an institutional portfolio in addition to still having the luster of the asset class that has not suffered a default in the 220 year existence of the US government.
Aside from (mis)perceived lack of risk due the track record which still sway many and we are still in a risk averse environment as long as the Great Recession continues. In addition the institutional demand is strong for often irrational regulatory reasons. First, in an environment of risk based capital requirements for institutions, the Treasury as an asset requires the least amount of capital of the institution. Since institutions are generally operating with cover up accounting and shallow capital ratios, the Treasury has a strong appeal. (See http://lewisspellman.com/videos/ways-it-melted-down-you-cant-handle-truth-1-5). Indeed, as previously indicated commercial banks substantially added to their Treasury holding in 2009.
Another source of Treasury appeal comes from the fact that pension funds have become regulatory constrained to match duration of assets with liabilities especially with highly rated assets. There is a great market scarcity of highly rated, long maturity bonds. Indeed, of the S & P 500 companies only 4 currently are AAA rated hence without Treasuries and government guaranteed debt, pension funds would have great difficulty meeting their high-quality maturity-matching asset requirements. While Moody’s has cleared warned that the Treasury AAA rating would be revised downward if entitlement were not reduced and reduced in the next year or two, we continue to have the market comforting factor of the Triple A rating. However, the UK and Japan have been downgraded in the last year so there is no reason to believe that Moody’s would not similarly downgrade the US but in the mean time the US looks better by comparison and if a portfolio requires sovereigns the Treasuries win by default.
Additional Treasury and dollar demand comes from foreigners who as the result of trade surpluses accumulated Dollars which are typically held as a medium of exchange and store of value in the dollar (and in turn Treasuries) as long as the Dollar is the reserve currency. The Dollar as the reserve currency would seem to come under pressure given the government’s long term deficit and debt problems however, however there are no equal competitors for the US dollar. In 2009, dollar skepticism was in the air and the Dollar came under market pressure and fell 15% against a currency basket. A great deal of the Dollar flight capital turned to the Euro which appreciated to $1.60. However, in late 2009 and early 2010, sovereign risk questions became more immediate in the Euro zone with Greece’s high profile problems and contagion to other Olive Belt countries so the safe currency pendulum swung back to the US Dollar and the US Treasury.
Given the skepticism of the ability of Greece and other Olive belt countries there was sudden widening of the yield spreads of the Euro Sovereign bonds. In a classic flight to quality pattern, the yields on Greek and other Olive Belt Sovereigns rose and the yield of German Bunds declined. This increase in spread with no change in the over-all level of rates is a classic “flight to quality” pattern which indicates that portfolio managers did not shift away from Euro sovereigns but rather sought to shift out of Greek and other less desirables and into German sovereigns raising the yield on for Olive Belt sovereigns but with German yields benefitting as capital fled in its direction.
This was no indication that German sovereigns were now a better credit, but they merely benefitted as capital was institutionally locked into sovereigns and the market sought to redistribute its holdings among the candidates. Much the same happened in 2010 to the Treasury yields as the Olive Belt flight caused capital to land in US Treasuries and drove short term Treasuries yields to all time lows of sometimes less than 10 basis points. Not only did the capital flight from risky Euro sovereign affect the Treasury but the Dollar also appreciated relative to the Euro. Basically the Euro sovereign distress made the Treasury look more appealing at least for short maturity Treasuries at this time.
While these institutional factors account for much of the markets continue support of Treasuries up at this time, some seek a risk factoring of sovereigns. At its most basic level this simply takes the form of asking the basic question of whether this year’s additional debt offerings will be financed by the market. This crude short term test comes down to whether the projected fiscal deficit can be financed this year. With a projected deficit equal to 10% of GDP once again in the US, and with a domestic saving rate of 5% that would get us half way to financing the deficit if most saving were funneled into Treasuries. This is happening in that consumer deleveraging takes the form of paying off bank debt and the banks in turn are expanding their Treasury holdings with the cash proceeds.
In addition to attracting domestic saving, the short term risk test of Treasuries also is viewed relative to attracting foreign saving to the US Treasury. Recently there has been some disturbing news in that both China and Japan the largest two holders of US Treasury debt in late 2009 and early 2010 became net sellers of Treasuries and with contentious tariffs issues being raised in the US Senate it is likely to affect China’s willingness to engage in the Treasury purchases as a quid pro quo for a waiver on retaliation for currency manipulation favorable to her exports.
Lastly, the market examines the inclination of the Fed to support the Treasury market as the buyer of last resort if both domestic and foreign savings is inadequate to finance the deficit. Now that the financial crisis is somewhat behind us, the Fed had made it known that the government must restrict itself to a structural deficit not to exceed 2.5 to 3% of GDP. This was clearly the message from Bernanke’s recent Congressional testimony. One certainly gets the feeling that he would need to be replaced for the Fed to embark on a serious debt monetization.