April 19, 2010
Bond-Buyers Voting against Obamanomics
It's getting harder to trust Washington's numbers. There was, for example, the not insignificant matter of fuzzy health care budgeting. How it was possible for the CBO to budget six years of health care spending based on ten years of revenues is still a puzzle to me. There was also the little matter of restoring a 22% cut in Medicare and Medicaid reimbursement for physicians, a problem solved by shifting the expense to a separate bill. Then there was the odd coincidence of the autumn Labor Department jobs numbers coming in above what private-sector economists estimated they would be just as the health care debate culminated. What luck for the Democrats, as the figures (later revised) implied a stronger economy more able to pay for the legislation.
As a result of such hijinks, most Americans do not trust what Congress and the president are telling them about the economy, but there does exist at least one accurate gauge of the economy and, in particular, of the impact of current deficits on future economic stability -- and that is the bond market. Unlike politicians, who have no difficulty arriving at revenue figures based merely on how much they wish to spend, bond traders judge the soundness of government credits based on actual spending and revenues.
How much confidence do our leading bond investors have in the Obama administration's management of the federal budget? Among income investors, no one is more esteemed than Bill Gross, manager for the last 23 years of the Pimco Total Return fund. As of March 31, the Total Return fund was underweight in U. S. Treasuries, and particularly in longer-term Treasuries: It held only 27.5% of assets in Treasury and U. S. agency obligations, and its holdings were concentrated (42.6%) in one-to-three-years credits. The fund's average duration of 4.6 years would seem to suggest distrust at this time of longer-term credits, especially those in the three-to-twenty-year range.
Another highly respected and highly successful bond investor is Michael Hasenstab, manager of the Templeton Global Total Return fund. As of April 6, the fund owned no U. S. government obligations. Over half of the fund, in fact, was invested in the government obligations of emerging markets such as China and India. As Hasenstab told Paul Kangas on Nightly Business Report back in April 2009, foreign markets are "a way of hedging against the potential inflationary risks that could amount over the medium term here in the U. S." as a result of quantitative easing. How much confidence does this suggest in the ability of the Obama administration to maintain monetary stability?
Then there is Wellington Management, a major investment advisory firm that recently issued the annual report for its balanced stock and bond portfolio. Wellington Management, a company with over $500 billion of funds under management, is at liberty to invest the bond portion of its portfolio in any combination of corporate bonds, asset-backed bonds, mortgage-backed securities, government agency credits, U. S. Treasury bonds, and other credits. According to its current report, Wellington has chosen to invest only 13.5% of its bond holdings in U. S. Treasury, government agency, and government mortgage-backed credits.
A typical bond index fund now invests 71.5 % of its assets in U. S. government and agency obligations and mortgage-backed securities issued by Fannie Mae, Ginnie Mae, and Freddie Mac. A portfolio weighting of 13.5% would seem, in essence, a vote of "no confidence" in anticipated future return of government bonds. It is the closest one can get to a completely objective report on the sustainability of the government's current fiscal policies.
Nearly all serious economists point out that it is not just the current annual deficit of $1.4 trillion that is unsustainable; it is also the compounding of the national debt that puts our future at risk. As Federal Reserve Chair Ben Bernanke told the Dallas Chamber of Commerce on April 7, future deficits of as "little" as 4% of GDP are unworkable. Government must reduce spending or increase revenues. Yet when is the last time government reduced spending?
Investment advisors who manage large income funds and annuity plans are not particularly interested in issuing political opinions, but in choosing to invest so little in U.S. government debt, the managers to whom I refer are nonetheless making a powerful political statement. What these investors are saying is that the debt of the United States is not very appealing at this time. Their avoidance of U.S. government debt speaks volumes about current fiscal mismanagement in Washington.
Over the past year, an investment in a long-term U.S. Treasury mutual fund would have lost 7% of its value. If intermediate-term interest rates were to increase by only two percentage points, the additional losses would amount to 20%. Just about the only ones overweighting such debt are Asian governments who view it in their best interests to subsidize the excessive spending of their largest trading partner. Yet even those investors are growing restive -- so much so that Treasury Secretary Geithner is now spending a good deal of his time shopping America's debt in foreign capitals.
The spectacle of a U. S. Treasury Secretary going begging in Asia is unprecedented in American history, and it is not a reassuring sign. Even at current levels of nearly $12 trillion, the national debt is frightening investors, and frightened investors demand higher rates of return. As expected, interest rates on ten-year Treasuries are beginning to move up, from 3.25% four months ago to just under 4% at present, thus reducing the appeal of U.S. debt and increasing the burden of servicing that debt.
Yet conservative budget projections by the CBO now suggest a national debt of $20 trillion by 2020. It is all but certain that foreign investors will demand an even higher rate of return on the credits of a nation whose debt exceeds its annual GDP. At that point, a vicious cycle ensues as higher interest rates drive up the cost of servicing the national debt, and the national debt is increased in order to service higher rates on ever larger balances. It's the same thing that happens with your Visa account balance, only larger.
Democratic politicians continue to put the nation's fiscal survival at risk even as they impanel a special committee (the Financial Crisis Inquiry Commission, chaired by a long-time member of their own party) to report on the causes of fiscal crises -- but not until after the November elections, lest any of their own names appear in the report. Investment advisors, on the other hand, must produce something more than excuses. What the advisors are telling us at the moment is that government debt is not a good deal. It is not a good deal for investors, and it is even worse for the nation at large.
Dr. Jeffrey Folks taught for thirty years in universities in Europe, America, and Japan. He has published many books and articles on American culture and politics.