As disaster looms, investors keep buying Treasuries

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The United States seems to have a free pass from global investors.

As U.S. politicians engage in non-stop brawling before the fast-approaching deadline to raise the country's debt-ceiling limit, the interest rates on its Treasuries remain historically low despite the apparent danger of imminent default.

Investors - specifically, foreign creditors - won't stop buying U.S. debt so long as the euro zone is undergoing its current woes, analysts say. Even a brief default may not be enough to shake the view that American debt is a better investment than the debt of many of its international counterparts.

"There are indications that a lot of foreign central banks are getting a little antsy, but you can't see it in U.S. Treasury rates," says Nariman Behravesh, the chief economist for information-services provider IHS. "The dollar is still the best-looking horse in the glue factory, in the sense that [it has]problems, but other countries have worse problems."

Mr. Behravesh believes the current prices on Treasuries reflect the market's belief that U.S. politicians will come to their senses and strike a deal before Aug. 2, when Treasury Secretary Tim Geither says the U.S. will have to begin drastically cutting spending to make good on its obligations and avoid a default.

If not, President Barack Obama may unilaterally step in to prevent what Mr. Behravesh believes will be a "horrific" impact on the U.S. economy from the suspension of federal spending, even for a few days.

"I joke and say American politicians and European politicians are in this perverse competition as to how you take a manageable situation on sovereign debt and turn it into full-blown crisis," Mr. Behravesh said. "I'm guessing the Europeans will win, in the sense their situation is so much more complicated politically."

Even in the event of a default, says John Higgins, an analyst at Capital Economics, the impact on Treasury prices "might be short-lived and less than some fear, as the loss to bondholders would probably be small - presumably amounting to only a short delay in receiving their cash flows on Treasuries."

"Provided Congress can agree on a credible strategy for deficit reduction in the relatively near future - i.e., shortly after next year's presidential election at the latest - we think investors' faith in U.S. government debt is unlikely to be shaken permanently," Mr. Higgins said Thursday. "If a ratings downgrade galvanized Congress [to implement a long-term fiscal solution] it could even have a positive impact on Treasuries in the medium term."

Mr. Higgins notes that Moody's, the credit-rating agency, downgraded Japan's sovereign credit rating repeatedly from 1998 to 2002 as the country's debt burden increased - but the yield on 10-year Japanese government bonds fell. "Japan's fragile economy led an increasing number of investors to conclude that the country required a prolonged period of ultra-loose monetary policy," he said.

He acknowledges that, unlike Japan, which was a nation of savers that was able to self-finance its debt, the U.S. is "an enormous" net borrower from abroad and is "vulnerable to a shift in the risk appetite of overseas investors."

Indeed, foreign purchases of Treasuries have fallen in recent quarters from their boom-like levels of recent years. Russell Napier, a global macro strategist with CLSA Asia-Pacific Markets, notes that in some years this influx of foreign cash exceeded the size of total Treasury issuance. Until 2010, foreign central banks were buyers of at least 40 per cent of what the Treasury cranked out.

However, foreign central banks bought just 16 per cent of Treasury issuance in the first quarter of 2011. As part of its quantitative easing, the Federal Reserve bought the equivalent of almost 200 per cent.

"A generation of investors has taken it for granted that capital will flow from foreign central banks into U.S. Treasuries," Mr. Napier said. "The Fed's actions have masked the foreign central banks' exodus from Treasuries."

There are explanations for this other than skepticism about the U.S.'s fiscal health, however.

As Mr. Behravesh notes, many emerging-market countries can keep the value of their own currencies low by supporting the greenback through Treasury purchases. In recent years, cheap currencies have promoted domestic economic growth in these countries by keeping the price of their exports competitive on international markets.

That may be changing as some of these countries struggle with inflation and look to find ways to slow things down; a rising currency achieved in part by dialling down the U.S.-dollar-stoking Treasury purchases is one of them.

To Mr. Napier, this effect will not be subtle, as he calls it a "structural distortion" in the U.S. Treasury market that "is about to unwind."

"The past two decades' flood of emerging-market central-bank capital will end as authorities take control of domestic monetary policy," he said in a mid-June research report. "Treasury yields will rise, potentially to deflationary levels."

THE MACRO EFFECT

Despite the bitter negotiations about raising the U.S. debt ceiling, Treasury bill rates have failed to shoot upward as would be expected if investors were worried that Washington might actually default. Instead of registering panic, the market seems to be confident that a political deal will be struck before the debt-ceiling deadline of Aug. 2.

One force keeping Treasury yields low has been foreign governments' desire for a competitive advantage. By buying U.S. Treasuries, foreigners prop up the greenback and keep their own currencies from rising. This helps these nations boost their export sales by keeping their goods cheap on international markets.

However, as these countries combat inflation, they may want their currencies to appreciate, because a stronger currency reduces the cost of buying foreign goods and helps fight rising prices. The growing need to fight inflation could remove a reason to buy U.S. debt

Credit-rating agencies have been threatening to downgrade U.S. government debt. But a series of downgrades doesn't automatically send government bond yields shooting upward. Look at Japan, which was downgraded as it struggled with its own rising debt in the 1990s, but still has some of the world's lowest yields.

Special to The Globe and Mail