US Debt the Best Refuge, But an Uncertain One

US Debt the Best Refuge, But an Uncertain One
The National 12/30/08

If angst was a currency it would have collapsed by now, so awash is the global economy with fear and anxiety.

One by one, the doors have been slammed shut on a range of investment vehicles, from the once-staid mortgage-backed security to hedge funds. The only risk-free option, it now seems, is US government debt. Two weeks ago, investors scooped up US$30 billion (Dh110bn) in short-term treasury bills with a yield of zero per cent, down from 3 per cent a year ago. So volatile is the global marketplace that investors are willing to pay a small fee to park their money in the safest place possible. Put another way, they are more concerned about return of their capital than they are about return on their capital.

Since then, interest on US treasuries across the curve has turned negative and demand for US debt is leavening the dollar despite record low interest rates and budget deficits. Some economists have celebrated this trend as a sign of the underlying strength of the US economy. In an editorial early this month, Ricardo Hausmann, the director of the Center for International Development at Harvard, argued that the willingness among investors to buy treasuries despite the country's massive bailouts proves that America's economic hegemony remains uncontested.

Not everyone is comfortable with Washington's emerging role as "super borrower", as Mr Hausmann put it. Bill Gross, who manages the world's largest bond fund, told Bloomberg this month that the market for treasuries was assuming "bubble characteristics" and hinted at the likelihood of a weaker dollar in the near future.

Mr Gross could be talking down a bull market he uncharacteristically failed to call. Having neglected treasuries all year, his company, Pacific Investment Management, missed out on the nearly 12-point return US treasuries have delivered this year, their best performance in eight years.

That said, Mr Gross is putting his money where his mouth is. Pimco is aggressively selling short-term bills by as much as 30 per cent below the Barclays Capital Index. Clearly, he sees what the US Treasury bulls are overlooking: that treasury bills and bonds are attractive only because of the lack of viable alternatives. If the events of the past 16 months have proven anything, it is that investment conditions and the economic fundamentals that create them can turn quickly.

Remember that treasuries are no risk only if the buyer keeps them to maturity. While the markets are preoccupied with deflation – as opposed to the staggering inflation that was concentrating minds less than six months ago – it would be perilous indeed to assume consumer prices will remain in negative territory for the life of a five or even one-year instrument. The return of even moderate inflation levels would be enough to trigger a flight from treasuries.

Keep in mind also that nearly two thirds of US sovereign debt is held by foreign governments, with China and Japan accounting for about half the total. At a time when the global economy is transitioning away from a single-engine model to a multi-engine one, it would be foolish to suggest America's monetary policies will dovetail indefinitely with the rest of world's. Should China decide domestic consumption is the best way to reverse its own economic slide, for example, it will sell treasuries to drive up the value of its currency, and thus the buying power of consumers. When a major player in any market sells or simply stops buying in significant quantity, others follow.

A UN report released on Dec 1 warned of a grim dollar outlook due to unsustainable levels of US debt. The annual report, the release of which was brought forward by a month due to the urgency of the situation, suggested a dollar devaluation could be accelerated by a renewed flight to safety, "though this time away from dollar-denominated assets, thereby forcing the US economy into a hard landing and pulling the global economy into a deeper recession".

Days before the UN report was unveiled, Reuters reported on Nov 26 an ominous rise in the number of investors buying insurance against a default of the US government. At one point, the rate for a credit default swap on the 10-year treasury widened to record levels, to 54.7 basis points. That means investors were prepared to pay $54,700 to insure a $10 million portfolio of 10-year paper.

The US economy has been underwritten by foreigners for so long it is regarded by too many Americans as a family trust fund, as if a reckless mismatch between means and lifestyle is something to be compensated for by an overindulgent rich uncle. If investors are piling into US government debt despite the country's looming $1 trillion budget deficit, you can be sure a lot of them are holding their noses while keeping at least one eye on the exits. That, along with the near certainty that next year will be just as angst-inducing as this one, is perhaps the safest bet of all.