Trust in U.S. bonds fell well be­fore down­grade threat

The Washington Times Weekly - - National - BY PA­TRICE HILL

The threat of the first down­grade of U.S. gov­ern­ment debt, for decades con­sid­ered the safest in­vest­ment in the world, came as a jolt to some in Wash­ing­ton two weeks ago, but fi­nan­cial mar­kets fore­shad­owed the move for months.

Many global in­vestors al­ready es­sen­tially down­graded the U.S. by vot­ing with their feet and in­creas­ingly shun­ning U.S. bonds.

Among the strong­est signs that the U.S. was los­ing its luster among the world’s in­vestors has been the steady de­cline of the U.S. dol­lar against most other cur­ren­cies as for­eign in­vestors, wor­ried about bur­geon­ing U.S. bud­get deficits, sought ways to avoid putting their cash in dol­lars and U.S. gov­ern­ment obli­ga­tions.

China and other ma­jor emerg­ing coun­tries that have in­vested most of their tril­lions of dol­lars in cash re­serves in U.S. Trea­surys for months have been seek­ing to diver­sify out of U.S. hold­ings on the ex­pec­ta­tion that the dol­lar will con­tinue to fall while bud­get deficits con­tinue to swell into un­charted ter­ri­tory of more than $1 tril­lion a year.

China, Trea­sury’s largest for­eign in­vestor, has made no se­cret of its un­hap­pi­ness with the pre­car­i­ous fis­cal sit­u­a­tion and heeded the ad­vice of a lit­tle­known Chinese rat­ing agency that down­graded the U.S. from AAA to A a year ago.

The price of gold, con­sid­ered the ultimate safe haven for in­vestors who worry about the de­te­ri­o­ra­tion of U.S. fi­nances, has soared in the past year and reached record highs of more than $1,500 an ounce two weeks ago af­ter Stan­dard & Poor’s Corp. be­came the first Wall Street agency to warn that the U.S. might lose its top AAA credit rat­ing.

Per­haps the mar­kets raised the big­gest red flag this year when the world’s largest bond fund, Pimco, an­nounced that it was dump­ing its Trea­sury hold­ings out of concern that the U.S. Congress and Obama ad­min­is­tra­tion are nowhere close to fac­ing the facts about the need to rein in fed­eral ben­e­fits pro­grams and raise taxes.

“Un­less en­ti­tle­ments are sub­stan­tially re­formed, the U.S. will likely de­fault on its debt” in a sub­tle and dis­guised way, said Pimco chief Wil­liam H. Gross.

Mr. Gross said he doesn’t ex­pect the U.S. to de­fault out­right on its obli­ga­tions and stop mak­ing pay­ments on the debt. Rather, he warned of a kind of “back­door” de­fault process al­ready un­der way, whereby the U.S. Fed­eral Re­serve and Trea­sury spur in­fla­tion through de­val­u­a­tion of the dol­lar to en­able the gov­ern­ment to “in­flate” its way out of the debt. At the same time, the Fed is hold­ing in­ter­est rates at ar­ti­fi­cially low lev­els that do not com­pen­sate bond­hold­ers for the in­crease in in­fla­tion.

While many in Wash­ing­ton have feared that China or Ja­pan might one day stop buy­ing U.S. Trea­sury bonds, China has di­ver­si­fied into other coun­tries’ bonds grad­u­ally to avoid im­pair­ing the value of China’s mas­sive U.S. hold­ings.

It was the sud­den exit of Pimco, one of the ma­jor in­vest­ment funds in the U.S., that should have set off alarm bells in Congress, an­a­lysts say.

Per­haps the mar­kets raised the big­gest red flag this year when the world’s largest bond fund, Pimco, an­nounced that it was dump­ing its Trea­sury hold­ings out of concern that the U.S. Congress and Obama ad­min­is­tra­tion are nowhere close to fac­ing the facts about the need to rein in fed­eral ben­e­fits pro­grams and raise taxes. “Un­less en­ti­tle­ments are sub­stan­tially re­formed, the U.S. will likely de­fault on its debt” in a sub­tle and dis­guised way, said Pimco chief Wil­liam H. Gross.

“Pimco out of Trea­surys? That’s like McDon­ald’s de­cid­ing not to buy any more ham­burger meat,” said eco­nomic com­men­ta­tor Gon­zalo Lira.

S&P’s warn­ing about a down­grade April 18 only “high­lighted a fact that ev­ery­body al­ready knows,” he said. “Trea­surys are nowhere near as gilded as peo­ple would like to be­lieve.”

“We shouldn’t be sur­prised at the con­cerns” raised by S&P, said Car­men Rein­hart, se­nior fel­low at the Peter­son In­sti­tute, not­ing that in­vestors world­wide have been sig­nal­ing concern about the de­te­ri­o­rat­ing U.S. fis­cal sit­u­a­tion for a long while.

With deficits rang­ing around $1.5 tril­lion re­cently and pro­jected to stay nearly that high for years to come, the fast-grow­ing U.S. debt bur­den is at the “ex- treme end of the spec­trum” among ad­vanced coun­tries, she said.

Ms. Rein­hart is co-au­thor of a much-dis­cussed study show­ing that coun­tries whose gross debt ex­ceeds 100 per­cent of their yearly eco­nomic out­put ex­pe­ri­ence more slug­gish eco­nomic growth. She said the U.S. is ap­proach­ing that level and has al­ready ex­ceeded that level if the debts of state and lo­cal gov­ern­ments and gov­ern­ment-spon­sored en­ter­prises by Fan­nie Mae are added.

“Mar­kets haven’t re­acted wildly to the S&P news,” be­cause most in­vestors were al­ready well aware of the dan­gers associated with the grow­ing U.S. debt load and the im­pli­ca­tions for the global fi­nan­cial sys­tem, she said.

Ms. Rein­hart said Wash­ing- ton’s usual ex­cuses for not tack­ling the debt prob­lem are get­ting “old.” Politi­cians ar­gue that the econ­omy is still frag­ile and an­other elec­tion is just around the cor­ner, so noth­ing se­ri­ous can get done while ev­ery­one is cam­paign­ing. Each party blames the other for years of in­ac­tion.

“Can any­one tell me if there is a good time to make dif­fi­cult de­ci­sions about spend­ing and taxes?” asked Ms. Rein­hart. “I re­ally don’t think there is a good time po­lit­i­cally.”

John Spinello, chief strate­gist at Jef­feries & Co., said S&P’s an­nounce­ment was a “shock” that shook the U.S. bond mar­ket for about an hour April 18. But then traders went back to wor­ry­ing about the more im­me­di­ate debt prob­lems in Euro­pean coun­tries such as Por­tu­gal and Ire­land.

“No one in the fi­nan­cial uni­verse” had ex­pected S&P to emerge as a “deficit cop for the gov­ern­ment” two weeks ago, he said. But in the end, the credit agency’s mes­sage to the gov­ern­ment to “get your house in or­der” was no sur­prise to mar­kets that have had to ab­sorb bil­lions of dol­lars of new Trea­sury­debt is­sues each week.

In the gold mar­ket, “fear about the nation’s debt and deficit” has helped cause a more than tripling of prices from $437 an ounce in 2005, and gold is likely to go still higher in com­ing months, said Scott An­der­son, se­nior econ­o­mist at Wells Fargo Se­cu­ri­ties.

“The big is­sue is the fate of the U.S. dol­lar in the face of soar­ing gov­ern­ment debt and deficits,” he said. Re­vers­ing the de­cline won’t be easy, he added.

“Find­ing a so­lu­tion to the nation’s bud­get woes will be a tremen­dous chal­lenge and will en­tail sig­nif­i­cant sac­ri­fices that many Amer­i­cans may be loath to en­dure.”

BLOOMBERG

And your chil­dren, and your chil­dren’s chil­dren: Pedes­tri­ans stop to view the Na­tional Debt Clock in New York on April 19.

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