National Debt: Budget Turmoil Slams Treasuries

This article was originally published by the Fiscal Times on Tuesday, May 3, 2011.

By Katherine Reynolds Lewis

Until recently, countries like Canada, Australia, and Norway could expect little more than scraps off the table after global investors parked most of their cash in U.S. Treasurys — long considered the gold standard for government securities. Throughout much of the past decade, more than two-thirds of the world’s cash reserves were held in dollars.

But all of that is changing as Wall Street, sovereign wealth funds, and other global financial concerns are looking askance at Washington’s long-term deficit problems and tumultuous political wrangling over the debt ceiling – and are scouting out more stable investments. The signs of this souring on U.S. debt are everywhere:

-- Major investors from PIMCO's Bill Gross to the central bank of China have pulled back on purchasing Treasury securities or have outright sold their Treasury bonds. Nine months ago, U.S. Treasuries accounted for half of the assets of Gross’s flagship Pimco Total Return, but that has shrunk to 30 percent now — the lowest ever in the fund’s 23-year history.

-- Individual investors have begun fleeing Treasurys as well. In March, the three worst-performing investment categories were U.S. short, medium and long-term debt, which lost $1.1 billion, according to Kevin McDevitt, analyst for Morningstar, which tracks mutual funds. Over the last 12 months, intermediate government bond funds lost 5.7 percent of their assets and long-term funds lost 14.5 percent.

-- And some sovereign wealth funds have shifted their focus from Treasurys to government debt in countries as diverse and disparate as Brazil, Malaysia, Canada, Australia, and the Scandinavian region — which while tiny markets compared with the United States have the advantage of appearing more stable.


If global investors start to shun U.S. debt as a safe haven — and the dollar as the world’s reserve currency — the federal government will face difficulty continuing to fund operations with trillions of dollars in debt. Rising interest rates would also cause borrowing costs to skyrocket and adversely impact other portions of the federal budget.

During the fourth quarter of 2010, U.S. households, the financial sector and foreign investors purchased Treasury securities worth nearly $300 billion less than the average purchases of the previous three quarters, according to an analysis of Federal Reserve data by Société Generale. China, the single biggest Treasury investor with just under 26 percent of U.S. debt, is shifting some of its Treasury investment to commodities and capital investment outside the U.S. In January, China reduced its portfolio by $5.4 billion to $1.15 trillion, according to data released by the Treasury Department.

“China is trying to buy as many hard assets outside the U.S. as possible,” said Marilyn Cohen, author of Surviving the Bond Bear Market and chief executive officer of Envision Capital Management, Inc. in Los Angeles. “The big, big money will just say, ‘What’s going on in Congress is reprehensible,’ and they will sell and short U.S. Treasurys. I’ve lived through a lot of bear markets, and we haven’t had a bloody one in a long time.”

“A lot of people talk about the Treasury market blowing up, and that's our concern as well,” said Aneta Markowska, senior U.S. economist at Société Generale, in an interview.

So what happened?

A lot has to do with the growing turmoil in Washington over the economy and huge deficits that seem to defy any solution. A recent report by Standard & Poor’s, warning that this country’s AAA bond rating might be in jeopardy unless the White House and Congress agree to a plan to stabilize the debt, has further fueled that concern.

The White House and Republican and Democratic congressional leaders are scheduled to begin formal talks this week on a long-term plan for reducing the $1.5 trillion deficit, but the GOP and Democrats have very different ideas of how to contain spending, entitlement programs including Medicare and Medicaid, and overhaul the tax code. Moreover, the Treasury is facing the possibility of defaulting on its debt unless Congress and President Obama agree to raise the $14.3 trillion national debt ceiling this summer.

Part of the growing antipathy towards Treasurys is a natural result of the Federal Reserve's purchase of an extra $600 billion in U.S. government debt in order to keep interest rates low and boost the economic recovery, according to some experts. Those low interest rates aren't very appealing to investors seeking a healthy return, after all.

Federal Reserve Board Chairman Ben Bernanke confirmed on Wednesday that the so-called quantitative easing program would be brought to a close on June 30. But in recent days, prominent investors have warned that investment may not return to the United States after Fed purchases end unless policymakers can demonstrate fiscal discipline and approve a long-term plan to bring down debt levels.

"If Washington D.C. continues to do nothing and the deficit continues to grow, our degrees of freedom, our flexibility slowly but surely becomes encumbered," said Robert Doll, chief equity strategist for investment giant BlackRock, in an interview with The Fiscal Times. "The longer we wait, the harder it's going to be to fix."

Already, global investors are testing out other investment markets. "We watch the foreign buyers very carefully because that's the biggest single category of buyers and the ones that could leave very easily," said Markowska. "They're buying less U.S. assets as a whole."

Government-owned sovereign wealth funds are investing in mines, plantations, gold and other commodity assets in Malaysia, Indonesia, Africa and South America, says Paul Schulte, global head of financial strategy for CCB International Securities, a subsidiary of China Construction Bank. "Many of the central banks that have been buying Treasuries previously have been signaling that they're not interested in keeping these high levels any more. The best-case scenario is that they keep the same amount. A less optimistic scenario is that they begin to sell off their Treasurys," Schulte says.

The shift away from U.S. debt and the dollar is already under way. Currently, 60 percent of the world's reserves are held in dollars, compared with 70 percent in 2003. "There are so many bonds being issued that people are fed up. People need to have confidence that the U.S. is getting its arms around the deficit," Schulte says.

One bright note comes in looking at the financial sector's net sales of Treasurys, said Richard Iley, chief economist for BNP Paribas in Asia, in an email. Rather than buying other assets with the money from selling Treasurys, banks have simply increased their excess reserves, which have climbed $500 billion since September.

Over the next two to three years, Treasury prices will drop and yields should move progressively higher, Iley predicted. "But this process is likely to be relatively orderly assuming the U.S. fixes its politics at some point over the next few years and adds genuine fiscal retrenchment to the natural improvement in the public finances that should begin to take hold as the economy heals and the unemployment rate makes further downward progress," he said.