It is hard not to marvel at the state of this lunatic assemblage collectively known as "the world economy." Treasury yield curves indicate that the US government can now borrow money repayable in one or three months' time for free or almost for free. Uber Cassandra Ambrose Evans-Pritchard of the Telegraph gleefully notes that three-month yields momentarily became negative, meaning lenders actually paid the Fed interest. This, of course, is beyond perverse. The US government, egged on by Wall Street lobbyists, lifted nearly all their unwanted rules pertaining to banking oversight. Yet in the end, even with all the rules bent in their favor, these banks only managed to mess things up while dragging the whole world down in the process. As investors of all stripes flock to Treasuries en masse, we now have the very questionable situation of the US government becoming America's sole unencumbered borrower.Think of it this way: in a place where private-sector financing has virtually evaporated, the US government is usurping the role of what used to be known as "the credit market." You name it: the banking industry, housing finance, and soon even automaker finance will fall under the watch of G-men. The US is setting a very questionable example for the rest of the world: the Washington Consensus folks prescribe discipline for others in times of trouble--witness the Asian financial crisis--but splurge when they themselves get into trouble. Charles de Gaulle once chafed at the "extraordinary privilege" America has of being able to print unlimited amounts of dollars, still the world's foremost reserve currency. Even now, this status allows the US to escape the fiscal discipline imposed on most other countries. Indeed, it seems that America's known intention of running over a trillion dollar fiscal deficit in 2009 has only encouraged folks to invest more in Uncle Sam's IOUs.
Or is the situation as rosy as that for America, Inc.? While I doubt whether American sovereign debt will ever be downgraded, what used to be the purview of credit rating agencies seems to be becoming the domain of everyone. These agencies having lost the collective faith of investors, it is now incumbent upon us all to be the ultimate arbiters of creditworthiness. Commentator James Saft of Reuters makes good points in his most recent contribution along these lines. In business textbooks at least, Treasuries are typically referred to as offering the "risk free" rate of return. In other words, the US government is the world's most reliable borrower when it comes to repaying debt. Given its mounting and onerous obligations, however, many are questioning if rock-bottom Treasury yields are really indicative of this status or if something else is at work:
The U.S.’s benchmark status as a “risk free” borrower is based on the idea that it is the best available credit, a solid gold borrower that will not default. And of course as Treasuries are denominated in dollars and as the state ultimately can print money to fulfil its obligations, that is correct.If true, the Fed's plan of depressing longer-term yields by buying up Treasuries is certainly worrying. If cheap and abundant credit brought us this mess, it is not clear to me how returning to conditions of cheap and abundant credit can clean matters up. Einstein once said that insanity is doing the same thing over and over again and expecting different results. He couldn't have called it better. That US sovereign debt now commands higher default premia than its German and Japanese equivalents should be a warning about the emerging folly of relying on credit ratings and yields in a world where governments, not markets, determine the allocation of credit. Caveat emptor: in the end, we alone are responsible for seeing through the follies of the Fed and other financial miscreants.
But investors clearly are becoming increasingly spooked that the United States’ difficult situation and its absolutely huge borrowing plans are making it a less certain risk. It now costs 60 basis points a year to buy a five-year credit default swap insurance policy against U.S. sovereign default, up from about 15 basis points in August and 100 times more than in January 2007 when it was 0.6 basis points. Clearly, somebody thinks risk free isn’t so risk free any more. This compares with a 50 basis point cost for German or Japanese debt. And remember too that 5-year Treasuries are only yielding about 1.70 percent, so a hedge against default would eat up quite a lot of one’s return.
Ironically, the Federal Reserve’s potential strategy of buying up government debt to reliquify the economy and avoid deflation may just make things worse. Federal Reserve chairman Ben Bernanke last week said the Fed could directly purchase “substantial quantities” of longer-term securities issued by the U.S. Treasury or government-sponsored agencies to lower yields and stimulate demand.
Fair enough, and it’s not as if I have a better plan for jump-starting the economy, but having the state buy up Treasuries will only put more distance between a genuine “risk free” rate and reality. Investors will be even more in the dark about what and where risk is. They will not know where Treasuries would trade without Fed intervention, nor will they know when and how quickly the Fed will roll back that intervention when growth and inflation inevitably arise again.
