U.S. treasury bonds — islands of refuge in a global economy torn by recession, a whiff of deflation, terrorism and recurrent Euro-crises — could be headed for a crisis of their own.

Although favoured by investors who are fearful of what the future holds, U.S. treasuries could eventually hit a wall and flutter downward. That barrier would be the massive debt the U.S. continues to accumulate from tax and import deficits, the cost of financing two wars and, of course, the cost of bailing out the domestic financial services system.

Crisis pricing is apparent in U.S. treasuries’ yields, as three-month T-bills offer 14 basis points compared with 49 bps for Government of Canada T-bills of the same term. At one year, the gap is even larger: 24 bps for U.S. notes vs 110 bps for Canadas. At five years, the gap expands to 152 bps for U.S. treasuries vs 225 bps for Canadas.

It’s not inflationary expectations that are driving these prices, as Canada’s expected inflation rate of 2.6% in 2011 is much the same as the 2.5% expected for the U.S. consumer price index, reports Bank of Nova Scotia in its Aug. 6 weekly fixed-income forecast. The dramatically lower yield on U.S. government paper is about investors’ fears for everything but the solidity of the U.S. government’s ability to pay its bills.

Confidence in the U.S. Treasury would appear to be based on the power of the Treasury’s printing press, not on any tax surplus in the foreseeable future. It is well known the Treasury’s cupboards are bare. U.S. federal debt totals US$14.1 trillion, which is 66% of current gross domestic product. If deficits continue, notes Jack Ablin, executive vice president and chief investment officer with Harris Private Bank in Chicago, U.S. debt will rise to 85% of GDP by 2014.

In comparison, Greece has a 120% ratio of public debt to GDP in 2010; although that’s worse than the U.S.’s, Greece is moving to curb its public spending. The U.S. has yet to do so.

At some point, U.S. treasuries’ yields have to rise to cover risks, Ablin says. Those risks could become apparent with bad economic news. “It could be a very negative employment number, worse than the market anticipates,” he says. “A bad number that implies recession would ordinarily push up bond prices as investors sell stocks and take refuge in fixed-income. But a strong hint of a downturn in the economy would suggest that government tax revenue would fall further and force up the deficit still more.”

Bond pricing on fundamentals rather than on fear would eventually force yields up, he argues.

The beginning of a collapse of U.S. treasuries’ prices would appear in a weekly bond auction that would be poorly received, Ablin suggests. The consequences could be devastating. If seen as investors’ reluctance to buy — and if it were accompanied by increasing shorting of U.S. bonds and even of the U.S. dollar — investors would sell down U.S. bonds, forcing interest rates to rise. There would be ripple effects as the term structure of interest rates rose, pushing up yields on corporate bonds and forcing banks to charge more to their borrowers.

The prospect of rising U.S. treasuries’ yields would have the effect of pulling money out of equities and into bonds. Canada, with a far healthier fiscal balance than the U.S., would be less injured; but with the health of our largest trading partner in doubt, Canada would not escape damage.

For clients who buy U.S. bonds for precautionary reasons or, perhaps, as a play on potential deflation that would raise real returns on bonds, the odds of a collapse of U.S. treasuries’ prices are low for now — but not forever.
@page_break@Much of the current predicament of the U.S. economy reads like a repetition of history. Kenneth Rogoff and Carmine Reinhart note in their 2009 examination of credit crises and bond defaults, This Time is Different: “The aftermath of banking crises is associated with profound decline in output and employment.” The authors point out that in these crises, house prices decline by 35.5% and unemployment rises by 5%, on average. That is precisely what has happened in the U.S. in the past few years.

The U.S. does not yet have the ability to buy its way out of its debt crisis. Only a strong economic revival will enable government tax revenue to rise and bond obligations to be paid out of a tax surplus. For now, the U.S. is just compounding its debt, much like a homeowner taking out a second mortgage to pay the interest due on the first.

The U.S. would not have to default for U.S. treasuries’ yields to rise. “It is a possibility,” says Adrian Mastracci, portfolio manager and president of KCM Wealth Management Inc. in Vancouver, “that U.S. debt could get to be priced not as AAA, as it is now, but as AA obligations.”

Bond-rating agencies have already put a spotlight on U.S. federal debt. On March 15, New York-based Moody’s Investors Service Inc. reported that the U.S. could lose its Aaa status — just as Japan, which has public debt equal to 200% of its GDP, has been downgraded from Aaa to Aa2. Japan, of course, is able to finance much of its government debt through the eagerness of its citizens to buy domestic bonds and to hold cash in yen deposits. Investors in U.S. government debt, especially foreigners, may not be so loyal.

It comes down to the sustainability of debt, the Moody’s report says. Interest payments, which averaged 10% of all U.S. federal revenue in 2008, fell slightly to 8.7% in 2010.

“If that trend were to reverse,” the Moody’s report says, “there would at some point be downward pressure on the Aaa rating of the [U.S.] federal government.”

The fine line that divides AAA from AA ratings is critical in pricing bonds in a market in which U.S. treasuries offer scant rewards. Moreover, for non-American investors, currency risk has to be priced into each trade.

“Many investors are now shorting the US$,” reports Sacha Tihanyi, a currency strategist with Scotia Capital Inc. in Toronto. “The carry trade was popular, given low U.S. interest rates. But that is now in danger because of high volatility in currency markets. The market is still focused on deflation.”

That is the saving grace in holding U.S. debt: in conditions in which there is a gain to the purchasing power of US$, fixed coupons have higher implied future value.

A swoon of U.S. treasuries’ prices is not likely to happen as long as the war and terror set the mood for fixed-income investors and financial advisors. The irony of the situation is that the U.S. government is getting a good deal on problems it has not solved.

“A climate of low interest rates makes it relatively inexpensive for the U.S. to finance its debt,” observes Tom Czitron, managing director and chief investment officer with Morrison Williams Investment Management LP in Toronto. He expects economic fundamentals to trump fear — eventually. “There will still be a demand for U.S. treasuries,” he says, “but with a higher risk premium.”

Much now depends on the U.S. and, of course, the global recovery. The irony that U.S. treasuries’ yields depend on a healthy recovery is not lost on advisors and their clients. If the private sector revives, generates more growth and pays more taxes, the U.S. current deficit and total deficit will decline. That will tend to support U.S. bonds, because the coverage ratio will improve. That would tend to maintain low yields. Deflation will make the coupons look better, but U.S. treasuries are still being priced as hoards for survival, not as capital for investment.

“Holding ill-financed bonds for future value is a poor long-term strategy,” says Tony Warzel, president and chief investment officer with Rival Capital Management Inc.in Winnipeg. “The problem is not knowing when U.S. treasuries’ comeuppance will happen.” IE