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U.S.Treasury Bonds in the Eye of the Financial Storm

Interest-Rates / US Bonds May 31, 2009 - 08:45 PM GMT

By: Money_and_Markets

Interest-Rates

Best Financial Markets Analysis ArticleBryan Rich writes: The U.S. Treasury bond market has become the focal point of financial markets for the past several trading days. And when Treasury bonds move, so does the dollar.


Market participants are looking for consensus on the penalties that may be levied on the U.S. government for its bailout and stimulus policies. Penalties in this case are expressed in lower demand for Treasuries and therefore, higher interest rates to attract demand.

Not a Normal Environment …

In normal environments — when the global economy is stable, the financial system is stable and advanced economies are growing — higher rates are a recipe for a stronger currency. That means the U.S. dollar would benefit from such an aggressive move in interest rates, as investors seeking higher yields flock to the Treasury market and the U.S. dollar. The climb in interest rates would typically be associated with a central bank that is attempting to cool off inflationary pressures from an expanding economy.

In normal environments, rising interest rates are a recipe for a stronger currency. But that’s not what’s happening now ...
In normal environments, rising interest rates are a recipe for a stronger currency. But that’s not what’s happening now …

That’s certainly not the case now …

Yes, interest rates are rising. The yield on the 10-year Treasury note leaped from 2.45 percent to 3.75 percent in just 10 weeks. But it’s not growth that’s driving yields on U.S. government debt … it’s inflation fears! Therefore, the dollar has been under pressure.

The U.S. government is adding trillions of dollars in new debt. And according to the IMF, the debt level in the U.S. is expected to surge from 63 percent of GDP in 2007 to nearly 100 percent of GDP by 2010.

But the dollar-bears and hyper-inflation theorists shouldn’t get too excited. In the worst global recession since World War II, inflation is not the problem. It’s deflation. Inflation will be a concern when all of the structural issues have been fixed, employment recovers and the money being printed turns into consumption.

Furthermore, considering the global scope of the economic and financial crisis, and similar policy actions taken by major governments, pinpointing U.S. specific problems only exposes the greater dangers to the global economy.

For now, Moody’s has quickly countered any speculation that the credit rating of the U.S. government debt was in jeopardy. The ratings agency endorsed the strengths of the U.S. economy and reaffirmed its top credit rating status.

And for a reference point in evaluating the impacts of quantitative easing and increasing debt loads in a crisis response, take look at Japan’s experience …

In 2001, the Japanese economy was suffering from its third recession in a decade, deflation, and a banking system crippled by bad loans. Japan moved short term interest rates to zero and then began a quantitative easing program.

The stimulus response meant government spending programs that pushed debt levels in Japan to 130 percent of GDP by 2002. And Japan spurred a government bond bubble through its government debt purchase program that later popped.

Sound familiar?

The result, however, was not inflation or devaluation in the yen. To the contrary, their currency strengthened. And over the course of the next five years, the Japanese economy began its longest period of growth since World War II — albeit export driven.

Debt Ratios Rising Everywhere …

The leading global economies are in repair mode, and it’s being paid for with more debt. So, on a relative basis, debt to GDP levels are expanding in most major economies as shown in the table below…

General Government Gross Debt as % of GDP
 
2007
*2010
Change
United States
63%
97%
54%
United Kingdom
44%
73%
65%
Japan
187%
227%
21%
Italy
103%
121%
17%
Germany
64%
87%
36%
Canada
64%
77%
20%
*IMF estimates

Higher Interest Rates are a BIG Problem for the Recovery Scenario …

'One in every eight Americans is now late on a payment or already in foreclosure as mounting job losses cause more homeowners to fall behind on loans.'
“One in every eight Americans is now late on a payment or already in foreclosure as mounting job losses cause more homeowners to fall behind on loans.” —Mortgage Bankers Association

The Fed has bought about $500 billion of debt to expand the money supply and force interest rates (particularly mortgage rates) lower, a feat that was going well until last week. Now mortgage rates are back above 5 percent, and billions of dollars worth of work by the Fed has been erased.

Even with manipulated mortgage rates, which went as low as 4.8 percent from 6.5 percent just nine months ago, the number of mortgage delinquencies and foreclosures hit record levels in the latest report. Now prime fixed-rate foreclosures are outpacing subprime.

This inflation scare and climbing interest rate scenario puts increased pressure on an already fragile domestic and global economy and increased pressure on the Fed. Moreover, a continued deterioration in the U.S. housing market is:

    • Not good for the U.S. consumer,
    • Not good for export-driven global economies,
    • Not good for the global financial system.

    Rather, it prolongs a problem that is at the core of the financial and economic crisis and exposes financial markets to more risk — just when the general sentiment is getting more optimistic.

    All of the economists polled by the National Association for Business Economics predict the recession to end by the first quarter of 2010. It’s this type of optimism that is feeding the risk appetite of investors. And it’s this type of optimism that creates increased vulnerability in financial markets to a negative surprise.

    With the growing complacency, another dip in this global recession could create some very gun-shy investors, a return to risk aversion and another leg higher in the dollar.

    Regards,

    Bryan

    This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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