Bloomberg News

Treasuries Rising Most Since 2008 as Budget Paralysis Seen

November 30, 2011

Nov. 21 (Bloomberg) -- With Congress at an impasse on how to reduce the U.S. budget deficit, the biggest rally in government bonds since 2008 shows no signs of letting up even as yields are about the lowest on record.

Treasuries have returned 0.9 percent this month, 3.4 percent since the U.S. was downgraded to AA+ by Standard and Poor’s Aug. 5, and 8.9 percent this year, according to Bank of America Merrill Lynch index data. The cost of derivatives to protect against a U.S. default is about half that for AAA rated Germany or the U.K. as Europe’s debt crisis has spread from Greece, according to data provided by CMA.

After the downgrade, and with lawmakers said to have failed to reach agreement on cutting $1.2 trillion from the deficit ahead of a deadline, U.S. bonds have still been the best investment this year. Yields may stay low as the Federal Reserve holds down rates and political wrangling in the U.S. threatens the global recovery. Spending cuts triggered by lack of a budget plan would lop as much as 2 percentage points off growth in the first quarter of 2013, according to JPMorgan Chase & Co.

“People are more concerned with risk aversion than they are with trying to hit a home run on return,” Jeffrey Caughron, an associate partner at Baker Group LP in Oklahoma City, who advises community banks on investments of more than $38 billion, said Nov. 17 in a telephone interview. “It makes sense to stay in Treasuries and high-grade investments until we see a demonstration of responsibility on the part of our Congress and some evidence that things are going to improve with the European situation.”

Yields Fall

U.S. debt gained last week as yields on Spanish bonds jumped and Mario Monti, Italy’s new premier, said the country’s ability to shore up its finances is critical to the survival of the euro. Yields on Treasuries due in 10 years fell 5 basis points to 2.01 percent, according to Bloomberg Bond Trader prices. The 2 percent securities maturing in November 2021 rose $4.06 per $1,000 face amount, to 99 28/32.

France’s 10-year government bonds yielded 3.7 percent, 1.9 percentage points more than German bunds as of Nov. 15, the biggest gap since the euro was created in 1999, and five times the 0.39 percentage point difference at the end of last year. While investors are demonstrating less confidence in French debt, the spread between benchmark Treasuries and bunds has tightened to 0.04 percentage point.

French Finance Minister Francois Baroin said in a speech in Paris on Nov. 16 that “the best way to avoid contagion is to have a solid firewall” by using European Central Bank support for Europe’s 440 billion-euro ($541 billion) rescue fund, a proposal rejected by German Chancellor Angela Merkel.

Default Swaps

While credit-default swaps tied to the U.S. climbed last week, contracts insuring against a default have fallen about 3 basis points to 52 basis points since the S&P downgrade, CMA data show as of Nov. 17. That compares with 95 for Germany, 227 for France and 92 for the U.K.

A basis point on a credit-swap contract protecting $10 million of debt for five years is equivalent to $1,000 a year. Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

“The posse’s on the move in Europe for sure, and they’ve been going from one country to the next,” said Ed Yardeni, president and chief investment strategist at Yardeni Research Inc. in New York, who coined the term bond vigilantes in 1983 to describe investors who protest monetary or fiscal policies by selling debt.

‘Political Gridlock’

“Unfortunately we’re going down the exact same road as the Greeks and the Italians and all the debt challenged countries,” Yardeni said of the U.S. deficit on Nov. 18 in an interview on Bloomberg Television’s “Inside Track” with Erik Schatzker. “The political gridlock really is just too damaging in the U.S., but we’re getting away with it. I think one of the reasons we’re getting away with it is because the Fed is the great enabler.”

The central bank has kept its target rate for overnight lending between banks at a record low of zero to 0.25 percent and has bought about $2.3 trillion of U.S. government and mortgage debt to drive down interest rates and stimulate the economy since 2008.

U.S. assets are benefiting from the global quest for safety as European leaders debate bailout measures and central bank action by Switzerland and Japan to devalue their currencies leave it as investors’ last haven. The dollar has rallied 8 percent since Aug. 1, when Congress approved a debt-limit compromise to prevent a U.S. default.

Stocks Fall

The S&P 500 Index has fallen 3 percent this month, while the S&P GSCI Total Return Index of 24 commodities declined 0.05 percent. The Stoxx Europe 600 Index has lost 6.2 percent and Japan’s Nikkei 225 Stock Average has dropped 7 percent during that period.

“The U.S. is the reserve currency,” Eric Stein, a money manager in Boston at Eaton Vance Management, which oversees $203 billion, said Nov. 14 in a telephone interview. “While it won’t last forever, that’s not changing at least in the near term,” he said.

A $1.3 trillion budget deficit in the fiscal year ended Sept. 30 was about 8.7 percent of gross domestic product, the third-largest percentage in the past 65 years, exceeded only by the deficits in 2009 and 2010, according to Treasury statistics.

U.S. marketable debt outstanding has doubled to $9.7 trillion since the end of 2007 as tax receipts plunged and the government boosted spending amid the worst recession since the Great Depression.

‘Most Liquid’

“The Treasury market, despite whatever ratings the rating agencies want to put on it, is still the most liquid market relative to developed markets out there,” said Thomas Chow, a senior money manager who helps invest $120 billion of fixed- income assets at Philadelphia-based Delaware Investments, in a telephone interview on Nov. 1. “The U.S. has an economy that on a relative basis looks better, given the uncertainty that is going on within Europe.”

The yield on Bank of America Merrill Lynch’s U.S. Treasury Master index fell to 0.97 percent, the lowest ever, after the downgrade by S&P, which cited weakening “political institutions.” U.S. government bond rates have declined 12 basis points this month to 1.06 percent as of Nov. 17, according to the index data.

Six Democrats and six Republicans on the supercommittee, created in August by the law that raised the U.S. debt ceiling, have until Nov. 23 to find $1.5 trillion in deficit reductions, and Congress must enact $1.2 trillion to avoid triggering automatic spending cuts of the same amount in 2013.

Failure Consequences

The bipartisan group is expected to announce that it has failed to reach agreement on at least $1.2 trillion in federal budget savings, a Democratic aide said. The aide, who wasn’t authorized to discuss internal matters publicly and requested anonymity, said in an e-mail yesterday that it was highly unlikely that the talks could be salvaged.

If the committee fails, “it’s possible the market might take more of S&P’s view that in addition we have a political process that doesn’t seem capable of fixing the long-term finances of the country,” Franco Castagliuolo, a money manager at Boston-based Fidelity Investments, which oversees $1.4 trillion, said Nov. 3 an interview. “Yields might not fall as last time.”

Democrats on the committee oppose reductions in programs such as Medicare, as sought by Republicans, unless accompanied by increases in tax revenue.

Congress is likely to fall short of its deficit-cutting goal, according to JPMorgan Chase & Co. and Credit Suisse Group AG. Treasuries may rally as riskier assets decline in such an outcome, described as “the most likely” by the Credit Suisse strategists Carl Lantz and Ira Jersey Nov. 4 in a report.

Partial Deal ‘Likely’

A partial deal on trimming the deficit is the most likely outcome, with odds of about 50 percent, JPMorgan Chief U.S. Economist Michael Feroli wrote Nov. 11 in a report. Whatever agreed upon reductions are short of $1.2 trillion will be made up by automatic cuts in 2013, he said.

The U.S. was stripped of its top ranking by S&P following months of political gridlock about deficit cuts as the government almost reached its borrowing limit. The rating company cited the country’s political process and criticized lawmakers. The U.S. has an Aaa rating from Moody’s Investors Service with a negative outlook, and an equivalent AAA grade with a stable outlook by Fitch Ratings.

New York-based S&P’s decision was flawed by a $2 trillion error, according to the Treasury Department. S&P disputed the Treasury’s assertions and said using the department’s preferred spending measures in its analysis didn’t affect its credit grade.

No Downgrade

A supercommittee failure “would not lead to a ratings downgrade by any of the three agencies as long as the automatic spending cuts are successfully implemented,” according to an Oct. 28 report from JPMorgan analysts led by Terry Belton, global head of fixed-income and foreign-exchange research.

S&P outlined on Aug. 5 a “downside scenario” that may lead to AA rating, in which the government failed to implement the $1.2 trillion in additional deficit cuts and a weakening economy. Should that happen, the firm forecasts higher U.S. borrowing costs as the 10-year bond yield climbs 50 basis points beginning in 2013, with net public debt rising to 90 percent of gross-domestic-product by 2015 from 74 percent this year.

‘More Negative’

The downgrade sparked a $9.7 trillion loss in market value from global equities last quarter. Government debt returned 6.4 percent, the most since the three months ended December 2008, Bank of America Merrill Lynch index data show.

A deadlocked supercommittee would “likely result in negative rating action,” which carries a more than 50 percent chance of downgrade during the next two years, Fitch said Aug. 16 in a statement.

While the failure “would be more negative,” the lack of an agreement wouldn’t itself cause a downgrade of U.S.’s top rating because of the automatic spending cuts, Moody’s said Nov. 1 in a statement.

U.S. borrowing costs of 1.1 percent are 4.4 percentage points lower than in 2000 when the nation had a $237 billion budget surplus during President Bill Clinton’s administration, Bank of America Merrill Lynch index data show.

“People saw rates fall after the downgrade and said it didn’t matter, and that’s the 100 percent wrong read,” said Curtis Arledge, chief executive officer of Bank of New York Mellon Corp.’s asset-management unit, said Nov. 15 at a conference in New York. “What the market is actually saying, in my opinion, is ‘holy cow, now we’re going to have to do something about it, that’s going to mean austerity. That means weaker economic growth, that means lower rates.’”

--With assistance from Liz Capo McCormick, Catarina Saraiva, Sara Eisen and Cordell Eddings in New York and Heidi Przybyla in Washington. Editors: Philip Revzin, Dave Liedtka

To contact the reporters on this story: John Detrixhe in New York at jdetrixhe1@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net


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