Part I refresher
Biggest risk: economic growth?In our surveys, inflation tends to be on top of investors’ minds, no matter how often government surveys show us that inflation is not the problem. Should inflation expectations continue to rise – and a reasonable person may be excused for coming to that conclusion given that the Fed appears to be increasingly focusing on employment rather than inflation – bonds might be selling off, putting upward pressure on the cost of borrowing for the government.
But if we assume inflation is indeed not an imminent concern (keep in mind that the Fed is also buying TIPS and, thus, distorting important inflation gauges in the market), we only need to look back at the spring of this year when a couple of good economic indicators got some investors to conclude that a recovery is finally under way. What happened? The bond market sold off rather sharply! A key reason why the Fed is increasingly moving towards employment targeting is to prevent a recurrence, namely a market-driven tightening, pushing up mortgage costs.
The government should be grateful that we have this “muddle-through” economy. Let some of that money that’s been printed “stick;” let the economy kick into high gear. In that scenario, the “good news” may well be reflected in a bond market that turns into a bear market.
Historically, when interest rates move higher in an economic recovery, the U.S. dollar is no beneficiary because foreigners tend to hold lots of Treasuries: should the bond market turn into a bear market, foreigners historically tend to wait for the end of the tightening cycle before recommitting to U.S. Treasuries.
The point we are making is that for bonds to sell off and the dollar to be under pressure, we don’t need inflation to show its ugly head; we don’t need China or Japan to engage in financial warfare by dumping their Treasury holdings. All we may need is economic growth! And while Timothy Geithner has studiously been trying to extend the average duration of U.S. debt, Ben Bernanke at the Fed has thrown him a curveball.
Perception is reality
One only needs to look at Spain to see that a long average duration of government debt is no guarantor against a debt crisis. Spain has an average maturity of government debt of 6 years, yet it does not take a rocket scientist to figure out that borrowing at 6% in the market is not sustainable given the total debt burden. As such, markets tend to shiver when confidence is lost, even if, technically, governments could cling on for a while when the cost of borrowing surges.
History may repeat itself
It was only 11 years ago that the US government paid and average of 6% on its debt. Sure the average cost of borrowing has been coming down. But no matter what scenarios we paint, if the average cost of borrowing can come down to almost 2% from 6%, we believe it is entirely possible to have the reverse take place over the next 11 years. Given the additional risks the Fed’s actions have introduced, the timing could well be condensed. But even if not, we believe it is irresponsible for policy makers to pretend interest rates may stay low forever (except, maybe, Tim Geithner’s steps to increase the average maturity of government debt; but as pointed out, his efforts may be overwhelmed by those of the Fed)... Read more from source Hidden Treasury Risks? Part II | 247Bull.com
