US Treasury bond auction signals storm clouds

Some very ominous and potentially extremely dangerous storm clouds seem to be gathering on the horizon of the global economy. There is evidence of unprecedented fundamental changes in the weather patterns surrounding United States government bonds, while there also are growing concerns that the Chinese economy, until recently expected to lead the global economy out of its slump, is developing the symptoms of a massive and dangerous bubble.

There were indications from last week’s auction of US Treasury bonds that 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 to have the safest credit anywhere in the world.

The prospect of default of the US 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 status seems to be something of the past.

For the first time in living history, some corporate bonds have become cheaper than what the US Treasury has to offer. Last week, Berkshire Hathaway was able to raise funds at a lower interest rate. 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.

Following on the heels of Greece, global investors now have to worry about the government debt situation in Portugal, which poses the question: 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, some observers are beginning to ask. Market veterans now are thinking that anything is possible.

Clearly, the market is having trouble digesting the huge amounts of debt from the US which 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% versus the current 4.75%.

It long has been wondered how much further the US, the world’s largest debtor nation, could continue to pile up record budget deficits and debt, and expect investors, particularly foreign governments, to fund the debt by enthusiastically buying the huge new issues of US Treasury bonds that are required.

The sparse interest in last week’s auction may have been the beginning of the answer. The dismal reaction to the note auction required higher yields than expected to move the new supply.

Many investors apparently are more comfortable with the risks of owning bonds backed by US corporations than the government. The big question is whether this fall in demand for Treasury bonds, and spurt in their yields, will prove temporary or if it is the start of a trend.

It would not be such a potential problem if the US did not require several more years of steady long lines of willing buyers and holders of its bonds to fund its growing debt.

And, warn some analysts, watch the stock market that has been on a strong run lately, convinced that the government always will be able to rescue the economy and any big player that gets into trouble.

It is this very assumption that is now under question, and which calls into doubt the whole Dow Jones rally of the past year.

The market is having trouble digesting the huge amounts of debt from the US which 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% compared to the current 4.75%.

Growing numbers of investors also are expecting that at its next policy-making meeting in late April, the Fed may step back from its pledge to keep short-term rates low for an "extended period".

Appetite for US debt has declined most markedly  with China, where there are growing concerns of a massive and dangerous bubble building in the economy on which so many observers had built hope to lead the global economy to sustained recovery after the financial crisis of 2007 and it resultant recession.

According to James Rickards, the former counsel for the infamous hedge fund Long-Term Capital Management, “It is the greatest bubble in history, with the most massive misallocation of wealth."

He told Bloomberg recently that the “Chinese central bank’s balance sheet resembles that of a hedge fund buying dollars and short-selling the yuan.

Fact is, China is no longer funding the US deficit. 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 also is ordained mathematically.

As Chinese exports have plummeted and government reserves have plateaued, China simply does not have the financial resources to continue buying Treasuries, which is unfortunate for the US at a time when its government borrowing needs have quadrupled, one commentator said last week.

At the same time, Forbes reported in December last year that on the face of it, China's economy is the envy of the world. As developed nations struggle to eke out a bit of growth and to get unemployment rates out of double digits, Chinese output gallops ahead at an 8% annual rate.

“This $4.7-trillion economy, it seems, is the world's dynamo and the prototype for the future.

“Take a close look, however, and you may come away thinking China resembles nothing so much as Japan shortly before its stock and property markets melted down two decades ago. A speculative frenzy of borrowing and bidding up is at work. If and when prices crash, there will be hell to pay,” the report stated.

The US government's $7.2 trillion in debt at the end of June last year represented 50% of gross domestic product. The Chinese government's officially disclosed $840 billion in public debt represents less than 20% of GDP. But the People's Bank of China and the Treasury also are liable for potentially another $1.5 trillion in off-balance-sheet debt. They also are obliged implicitly  to backstop $1 trillion, both in loans that "policy banks" were directed to issue, even when they made no economic sense, and non-performing loans that the government removed from the books of state-owned commercial banks over the past decade.

This all adds up to a national debt equal to over 70% of 2009 GDP. That does not count any loans generated this year which may go sour amid a 30% increase in debt balances nationwide.