Pressure is building in one of the world’s most important markets, US government bonds. Dramatic changes in the landscape are likely.
The first shock was the recent speech by President Obama about US fiscal policy. For some time investors and commentators have been concerned about the massive build up of US debt: a deficit this year of 10-11% of GDP, so the same order of magnitude as the weakest European countries, while the debt to GDP ratio has reached a post war high.
At last, US politicians appear to be closer to biting the bullet. The President unexpectedly proposed big cuts to lower the budget deficit back to 2.5% of GDP by 2015. There had been earlier proposals, a Deficit Commission report last December, and a Republican programme earlier this month. By raising the stakes Obama’s speech was potentially a game changer. He has thrown the gauntlet down to Congress to consider his proposals, hoping that Vice President Biden can reach some ‘mega deal’ by June.
The second shock was the announcement by the credit rating agency Standard & Poors that it was revising down to negative its outlook for the USA’s AAA rating – indeed they warned there was a 1 in 3 likelihood that they could lower the long-term rating within 2 years. Financial markets were convulsed by this news; a downgrade could mean more expensive borrowing not only for the US government but also for many companies. If overseas investors pulled money out of US assets, the US dollar could weaken sharply.
The very threat of such disruption will, hopefully, encourage US politicians to redouble their efforts to reach agreement. This is not the first time such a downgrade has been threatened. In 1996 another agency, Moodys, put the US on watch, for a few months.
Now for the bad news. The S&P is worried about policy congestion in Washington. There are very large policy differences between the Democrats, Republicans and groupings such as the Tea Party. For example, Obama has proposed $3tn of spending cuts and $1tn of tax increases, while the Republicans suggested $6tn of spending cuts plus $2tn of tax cuts to reach a net $4tn. Specific areas of disagreement include repealing the Bush tax cuts, lowering defence spending or savings in Medicare. More worryingly, both camps rely on rather rosy scenarios. Obama has assumed that higher tax rates do not damage the economy, that interest rates stay unusually low, and that the economy avoids recession for a dozen years.
Economists have warned of the dangers for some time; in its recent Fiscal Stability report the IMF wrote about the fiscal crisis – not just the annual deficits but especially unfunded liabilities such as Social Security and Medicare, estimated at some $80tn in coming decades. Why haven’t US bond yields sold off more, as many commentators expected? The answer lies in the relationship between US fiscal and monetary policy – the US central bank is still buying bonds under its QE programme, while giving very strong signals that it does not expect to raise interest rates for the foreseeable future.
This summer could be very dangerous though. The QE programme ends in June, while by July Congress must decide whether or not to increase the $14.3tn ceiling on US debt issuance. Discussions could be tortuous; either side might feel emboldened to use this extension, or the threat of a government shutdown, to try and obtain concessions from the other. If Washington can agree sufficient fiscal austerity, US bonds could be very well supported; if not Treasuries could suffer serious damage. Under the ground, the pressure is building, potentially for a very large tremor in a few months time.
Source : Standard Life Investments Press Release
