Following in Europe’s mistaken footsteps
As American politicians of all stripes were doing their best to produce more fodder for the late-night TV comics last week, the markets appeared to be coming to terms with Washington’s peculiar brand of lunacy.
U.S. Treasuries staged a rally on Friday, sending the yield on the benchmark 10-year bond to its lowest level in eight months. Yes, even with all the squabbling between Republicans and Democrats – not to mention the bickering among Republicans themselves – over raising the legislated U.S. debt ceiling, credit for Uncle Sam is still cheap, thanks to fresh worries about the struggling U.S. economy.
Stocks had a miserable week, but this also had as much to do with the latest batch of dismal economic news as the fears the politicians wouldn’t set aside their narrow self-interests long enough to boost the $14.3-trillion (U.S.) debt cap. Yields went up on short-term U.S. notes maturing this month, but that direction will be reversed quickly once their safety is assured.
“The markets are having a hard time discounting the possibility that politicians truly are insane,” Bruce McCain, chief investment strategist with KeyCorp’s private banking arm, memorably told Bloomberg.
So let’s look past this temporary bout of political weirdness to what lies ahead. What our perpetually cloudy crystal ball shows is a hopelessly gridlocked Washington that seems likely to muddle along, following the European pattern of kicking the debt can down the road as long as possible. The inevitable reckoning that debtors normally face after living beyond their means for years is not coming any time soon, no matter how much the Tea Party types kick and scream.
A few weeks ago, “we would have universally said they’re going to get a deal done that’s going to cut expenses and it’s going to be good for financial markets,” says David Ader, who oversees government bond strategy at CRT Capital Group in Stamford, Conn., when he isn’t helping us interpret the tea leaves. “The worst-case scenario, short of a default, would have been this sort of postponement [in tackling the deficit]. Which looks like it’s going to have to be the outcome. It is just going to stretch out the uncertainty and the rancour, like they did in Europe.”
The bond market has already been positioning itself for just such an outcome, as illustrated by low trading volumes and a preponderance of neutral positions. “People don’t have a lot of exposure. They don’t have risk on, “ Mr. Ader says. “The lack of activity – a willingness to put on a risk position – is being mistaken for a degree of optimism about the outcome.” What it really signifies is that institutional investors don’t know what to do.
Meanwhile, though, U.S. Treasuries and other U.S. dollar-based assets remain the safe harbour of choice for global funds that already have more than enough gold, Swiss francs and Japanese yen in their vaults. Especially with the global economy stumbling.
True, the U.S. dollar weakened late last week. But it has fared remarkably well, considering the political crisis in Washington, the warnings of a possible U.S. downgrade from the rating agencies and the economic setbacks. “In the face of Europe’s Greek [debt] plan, you would have thought there would be a euro rally and we would have gotten nailed,” Mr, Ader says. “But no market, globally, is responding in a big way. We ask ourselves: ‘Where are the bond vigilantes?’ You’d think that they would come into play.”
When all is said and done, investors will not be abandoning U.S. debt or dollars any time soon, even if rating agencies make good on their threats to strip the U.S. of its coveted Triple-A rating, in the absence of a credible plan to rein in spending and cut the soaring deficit.
“We all know that we [the U.S.] can cut expenses. We can raise taxes. It’s not an existential thing like what is going on in Europe,” Mr. Ader says. “The market fully recognizes it. It can get upset with Congress. But at the end of the day, it’s not a question of whether you’ll get your money.”
Mr. Ader likens the vastly different situations facing Europe’s peripheral basket-cases and the U.S. to two groups of diners at a pricey restaurant. The Greeks and other poor euro zone relations don’t have enough money for the tab, but proceed to order the most expensive entrees anyway. The Americans can afford anything on the menu, but they haggle over the size of the tip and overstay their welcome.
And what happens once they push themselves away from the trough – er, table?
Regardless of what the politicians or the rating agencies decide, “our thesis remains the same,” says Eric Hickman, managing director with Denver-based Kessler Investment Advisors, which advises international clients on their Treasury strategies. “We’re coming into a period where there is greater austerity throughout the world. China appears to be slowing down. We certainly seem to be slowing down. And without new stimulus, we’re going to see a steady [economic] erosion.” That is bad news for the millions of Americans looking for a job, but good for those holding fistfuls of U.S. government debt.
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