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U.S. bonds plunge as tax plan lifts economic outlook

US President Barack Obama

Photographer:/Saul Loeb/Getty Images

President Barack Obama is stirring up global bond markets.

Investors are recalculating their assumptions about the world's largest economy after Mr. Obama's unexpected compromise with the Republican Party to extend U.S. income-tax cuts. Economists called the move a "game changer" that is set to provide a pop to economic growth in the U.S. in 2011.

It's a much-needed note of optimism about a long-suffering economy, struggling with high unemployment and little growth. But good economic news is often bad for the bond market. A stronger economy could nudge up inflation, a bond investor's foe since inflation erodes real returns.

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U.S. bonds staged the biggest two-day drop in two years on Tuesday and Wednesday, sending yields sharply higher. The yield on 10-year Treasuries has risen almost a quarter of a percentage point this week, closing at 3.24 per cent Wednesday. That's about a full percentage point higher than October, when the Federal Reserve initiated its plan to buy $600-billion (U.S.) of longer-term Treasuries and most analysts expected the U.S. economy would do little more than muddle through 2011.

In perhaps the clearest sign that the bond market has shifted off kilter, U.S. 10-year yields temporarily dropped below the yields on comparable Canadian securities, a rare occurrence that last happened in May. The rate investors demand to buy German bunds jumped above 3 per cent for the first time in seven months, and the yield on five-year Japanese debt gained the most in more than two years, according to Bloomberg News.

For Mr. Obama, the jump in Treasury yields is both a positive development and a troubling omen.

The immediate reason for the increase appears to be expectations that the tax compromise will spark economic growth, something that tends to make stocks more attractive over bonds. Economists at Deutsche Bank AG, for example, said the $120-billion payroll tax cut in Mr. Obama's tax plan alone could add 0.7 percentage points of economic growth in 2011, which would push their forecast to around 4 per cent.

Faster growth might also reduce demands on the Fed to complete its Treasury-purchase program, which would remove future demand for U.S. debt and reduce prices. (When bond prices fall, yields rise, and vice versa.)

But the other main reason for the spike in Treasury yields is growing worry that the U.S. government is incapable of taking its $1.3-trillion deficit seriously. The entente between Mr. Obama and Republicans would temporarily extend tax cuts and introduce new measures that could cost more than $900-billion over two years. So at the very moment much of the rest of the world is preoccupied with reducing debt, the U.S. government is adding to it.

The move in bond markets is all about "changing assumptions about growth," said Mark Chandler, a fixed-income analyst at Royal Bank of Canada in Toronto. "It could mean the Fed has to do less. It also means, at some point, there's a likelihood that the U.S. will come under pressure over debt and deficits."

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Worries about a possible U.S. fiscal crisis likely explain the collapse of the gap, or spread, between 10-year Treasuries and their Canadian counterparts. The yield on 10-year Canadian notes was little changed Wednesday and was only six basis points higher on the week, reflecting confidence in Canada's relatively stronger fiscal position. The Canadian 10-year yield closed at 3.244 per cent, compared with 3.2398 per cent for the comparable U.S. security, according to Royal Bank.

It's possible that Canadian yields will spring clear of U.S. yields as early as Thursday, analysts said. That's rare because the Treasury market is the biggest in the world, making it the global benchmark because securities always are in ready supply and the U.S. government has never defaulted on its debt. Canadian yields tend to trade higher than U.S. yields only during times of serious stress in the world's largest economy, such as during the 2001 recession.

In a commentary, Glen Hodgson, chief economist at the Conference Board of Canada, says the world has entered a "new age of fiscal austerity" in which markets will punish any government that doesn't implement a credible deficit-and-debt reduction plan - something the U.S. has yet to do.

Because it controls the world's de facto reserve currency, the U.S. has more wiggle room than most countries, but not much more, Mr. Hodgson said. "If it does not address its fiscal imbalance, bond markets will begin to signal their discomfort through a growing risk premium on U.S. borrowing," Mr. Hodgson said in an email from Toronto.

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About the Author
Senior fellow at the Centre for International Governance Innovation

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.Previously, he was Report on Business's correspondent in Washington. He has covered finance and economics for a decade, mostly as a reporter with Bloomberg News in Ottawa and Washington. A native of New Brunswick's Upper St. More

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