With the U.S. budget gap reaching a mind-bending level, why are Treasury yields lower than when the government ran a surplus more than a decade ago?
Tea Party stalwarts are angry at the U.S. government's rising tide of red ink. Print and broadcast media are full of dire warnings about the debt and the deficit. Some Wall Street analysts' worry that the government's spending will topple the nation's triple-A credit rating, bringing the economy to its knees. Even economists who support the Bush and Obama Administrations' dramatic fiscal actions to prevent the Great Recession from morphing into a Great Depression agree that the federal budget deficit and mounting government debt is unsustainable over the long haul. But the agreement stops there. The raw, vicious, partisan politics splintering the country from Washington, D.C., to Washington State makes any move toward a solution, let alone a rational dialogue, seemingly impossible. This is one of those times when conventional wisdom looks to be right: Thanks to a broken-down political system, the debt and the deficit are only going to get worse and worse until America sinks into a Greece-like crisis. But here's the puzzle: If the federal government's fiscal position is so financially parlous, its need for debt financing so insatiable, and our political system so bankrupt, then why is the interest rate on U.S. government bonds lower than at the beginning of the 2000s, when the government ran a budget surplus and was paying down its debt? For example, the yield on the benchmark 10-year U.S. Treasury bond is currently around 3.8%. Last year, the yield averaged 3.3%. The budget deficit in the latest Economic Report of the President is projected to be -$1.5 trillion in 2010. Last year, the White House Council of Economic Advisers pegged it at -$1.4 trillion. Yet from 1998 through 2001, when the U.S. government was in a budget surplus for the first time in three decades, the 10-year Treasury bond yield ranged between 5% and 6%. What is the message in government bond yields? That the conventional fiscal pessimism could be wrong, deeply wrong. Valid Price Signals?
Of course, we know that the market—the collective judgment of millions of investors worldwide risking money and reputation daily—isn't always right. (The late, lamented real estate bubble will attest to that.) Still, the market is a wondrous competitive "system of telecommunications," in Friedrich Hayek's apt metaphor. The price signal should be taken seriously. It's also doubtful that the world's hard-nosed bond market vigilantes, the metaphor for the role of fixed-income investors to guard against fiscal and central bank profligacy, have suddenly gone squishy. The memorable words of James Carville, President Clinton's campaign manager, still ring true. "I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a.400 baseball hitter," he said. "But now I want to come back as the bond market. You can intimidate everyone." Bond-trader calmness partly reflects the reality that much of the bluster and wailing about the deficit is simply nonsense. "No doubt, there is plenty to worry about. There always is!" writes James W. Paulson, chief investment officer for Wells Capital Management, in his latest economic and investment newsletter. But his advice for dealing with the nation's obsession with the next disaster in the making is to "ignore the rabble." Optimism in the Yield Curve
The U.S. economy has barely emerged from its worst downturn since the 1930s. Demand cratered, tax revenues fell, and unemployment soared. Money managers well know that the extraordinary fiscal and monetary policy initiatives in the U.S. and elsewhere kept the economy from falling off the precipice. It's still too early to remove the system from life support, although the recent increase in the yield curve—the spread between short- and long-term rates on Treasury debt—offers a slice of growth optimism. Rates could go higher, but not because the bond market vigilantes are running from the federal deficit and government debt. It's a well-tested rule of thumb that a steep curve indicates expectations of strong future growth and, by the way, flush government tax coffers. Investors also seem to have faith that the Federal Reserve Board under Chairman Ben Bernanke will do a good enough job that inflation won't spiral out of control. The current core rate of consumer inflation remains tame. The 10-year Treasury Inflation Protected Securities (TIPS) are forecasting an average 2.3% inflation rate over the next decade. The Fed has already started its move from combating recession to dealing with an expansion with its hike in the discount rate to 0.75% from 0.50%. The most important factor behind investor steadiness may be a considered judgment that the U.S. political system may be messy and noisy, but it has also proven itself to be highly flexible and adaptable. The insight was noted by Daniel Cohn-Bendit in the mid-90s. Better known as Danny the Red, the charismatic student who briefly led the 1968 revolt in France, Cohn-Bendit was equally dismissive of the French government three decades later when the mandarins abruptly announced a series of major policy changes to close yawning deficits. The nation was rocked by strikes, and the government retreated. "In America, before major changes in anything there are Congressional hearings, public debates between Congress and the President, and a whole process of public discussion that is completely absent in France," Mr. Cohn-Bendit told the New York Times. From Deficit to Surplus
That conversation is in full throat. Despite widespread cynicism about the President's new blue chip panel on deficit reduction, he did get two respected power brokers to sign on as co-chairmen, Erskine Bowles, a White House chief of staff under President Clinton, and Alan Simpson, a former Republican senator. This type of initiative has worked before. When federal budget deficits threatened a tide of red ink "as far as the eye could see" after Ronald Reagan's Presidency, his successors Bush and Clinton, along with enough members of Congress, managed with time to bring the budget into surplus. Resilience is a hallmark of the American political system. A major strand of America's political history is that whenever widespread economic abundance is threatened, the political system adapts. In his magisterial People of Plenty: Economic Abundance and American Character, the historian David Potter argued in the 1950s that what American democracy was really committed to "was realizing the potentialities of our unmatched assets and raising our standard of living." From 19th century land reform through the New Deal, the "tactics by which this was done changed as the form of abundance itself changed, but the basic purpose—to keep our population in contact with the sources of wealth—has remained steadily in the ascendant throughout our history." Simply put: Wall Street is betting that history still holds. The rules will change if the deficit and debt truly threaten prosperity. Don't sell the American political system short—at least not yet.