Unprecedented relationships are beginning to form in the global bond markets. For as long as anyone can remember, the US government has enjoyed the lowest cost of borrowing whatever the maturity of the bond, because the US has been deemed the safest credit anywhere in the world. The prospect of default of the United States has been considered so low that academics describe the US Treasury bond as the risk-free bond., from which all other credit instruments are priced.
This relationship seems to be breaking down, for the first time in living history. This past week Berkshire Hathaway was able to raise funds at an interest rate lower than that of the US Treasury. Headlines in the financial press stated: “Obama Pays More Than Warren Buffett For Money.” The bonds of DuPont and other stalwart corporate names also yielded less than equivalent maturity Treasuries.
The Treasury Department is now coming routinely to market with bond issues that just two years ago would have been considered preposterously large. All of this is necessary to help the US fund its projected $1.9 trillion budget deficit, up from about $400 billion a few years ago (not counting the issues necessary to fund the Iraq War). Today the Treasury offered $42 billion in 5 year notes, and the auction did not go well. The bid-to-cover ratio, which measures the excess demand for the bond, was disappointingly low. Moreover, indirect bidders took only $16.6 billion of the issue, and this category includes foreign central banks. Lately there has been a category added by the Treasury called “Direct Bidder”, which is not specified, but is assumed by some to be the Federal Reserve.
This means that the one arm of the US government is buying the debt issued by another arm – never a good result because no new cash flows into the Treasury coffers. The rest of the bond issue was taken up by the Primary Dealers, who are required to bid and buy Treasury issues. The problem here is that these Dealers are holding on to more of this paper now that the central banks, especially China, are no longer funding the US deficit. Also, with the collapse of Bear Stearns, Lehman Bros., and Merrill Lynch, there are fewer large Wall Street banks to support the government bond market. This is one of the consequences of concentrating so much power and wealth in what are now six large banks.
China’s disinterest in buying US Treasuries traces back at least to October last year, when the Chinese government indicated it was scaling back on its investments in US securities. While this announcement can be interpreted politically as a rejection of US government policies and its excessive borrowing needs, the Chinese reaction is also mathematically ordained. As Chinese exports have plummeted and government reserves have plateaued, China simply hasn’t the financial resources to continue buying Treasuries, which is unfortunate for the US at a time when its government borrowing needs have quadrupled.
It did not help today that Portugal’s government bonds were downgraded to AA- by the Fitch rating service. This took the European debt crisis to another stage, with the problems with Greece’s debt still unresolved. The German government remains adamant that it will not provide funds to Greece, despite the efforts of France and other countries to organize a pan-European rescue for Greece. Thus there is a talk of a possible Greek default, not because Greece can no longer borrow on the public markets, but because Greece can no longer <i>afford to borrow.</i> The rates being charged by the market – 12% and higher – are typical for a junk debt issuer, but more specifically, the Greek government says it cannot afford to pay interest at such a rate. It simply doesn’t have the cash. The late economist Hyman Minsky would recognize this as a Minsky moment, when a borrower engaged in Ponzi finance (taking on new debt to pay off old debt) realizes it can’t afford even the interest on new debt.
Complicating this picture is the ongoing investigation as to whether Greece cheated in obtaining entry to the euro by hiding debt through maneuvers like the Goldman Sachs swaps. Also, Germany in particular is angry at revelations that a major Greek bank – Hellenic Bank, as well as the Greek government Postal Service bought credit default swaps betting that the Greek government would default. What sort of inside information did they have?
As if dealing with all this was not enough, global investors now have to worry about the government debt situation in Portugal. Who is next? The prime candidates for ratings downgrades are Ireland, Italy, and most worrisome, the United Kingdom. The UK’s debt situation is somewhat worse than that of the US, but if the UK is dragged into this mess, can the US be far behind?
Market veterans are beginning to think anything is possible. Clearly, the market is having trouble digesting the huge amounts of debt from the US that are issued weekly, and interest rates on this debt are rising inexorably. There is a point where the pressure on US Treasury prices could cascade lower into a collapse, leading to long bond interest rates of 7.5% vs. the current 4.75%.
It is also possible that we could have another credit crisis among the commercial banks, which would cause a rush to safety by investors. This would be halfway comforting to the Treasury, because investors would once again try to get their hands on government paper at any cost, thus driving down interest rates. But it would have serious consequences for the US economy, more than likely driving it back into recession or something worse.
This is the dilemma facing the US – or maybe we should describe it as a trilemma. The third option, cutting back on government spending, is given lip service by the Obama administration because the economic cost of withdrawing all the stimulus in the market at the moment would be as recessionary as another bank crisis.
We can certainly say we live in historic times. It would be unprecedented if this current situation persists, wherein corporations can borrow more cheaply than the US government. But it does seem likely to persist, because the Treasury demand for so much cash is so persistent. Many of us have warned about this very problem, and the inflection point where it becomes obvious that the Obama administration can no longer willy-nilly borrow however much it wants to paper over economic and financial problems. We seem to be at that point. Watch for continuing hints that the US Aaa rating is in jeopardy (Moody’s has already suggested as much), and watch the stock market, which has been on a tear lately, convinced that government will always be able to rescue the economy and any big player who gets into trouble. It is this very assumption which is now under question, and which calls into doubt the whole Dow Jones rally of the past year.
First published in The Agonist