Famously cautious, bond investors tend to sell at the first hint of trouble; movements in bond prices and yields serve as a good indicator of future problems. Trends in the bond market suggested that trouble was brewing in Greece and Ireland in late 2008 and early 2010, long before the major US credit rating agencies downgraded these nations.
Governments worldwide fear the wrath of credit raters and bond investors for good reason: A downgrade or selloff ratchets up borrowing costs at the worst possible time–when a fiscally weak nation is already struggling to repay its debts.
The heated debate between the Obama administration and Congressional Republicans over a deal to raise the US debt ceiling has dominated the headlines in recent weeks. With the President refusing to consider a plan that doesn’t include a plan to increase governmental revenue and the GOP staunchly opposed to raising taxes, the two sides appear more interested in trading barbs than reaching a compromise at this stage in the game.
This political brinksmanship is hardly a surprise with the 2012 election cycle looming on the horizon.
Meanwhile, in his testimony before Congress this week, Federal Reserve Chairman Ben Bernanke painted a grim picture of the potential fallout if the federal government were to default on its sovereign debt obligations. The major ratings agencies also warned that such an occurrence could spark a downgrade of the US’ AAA sovereign credit rating.
All of this uncertainty has overshadowed positive earnings results, preventing the stock market from making any headway.
But amid all the uncertainties and doomsday predictions, the market for US government bonds appears wholly unconcerned.
This graph tracks the yield on a 10-year bond issued by the US government. Bond yields move inversely to price: When the yield on the 10-year bond drops, demand for this security is on the rise, pushing up the price. Ten-year US Treasury bonds currently yield 2.91 percent–approaching the lowest level since late 2010. In other words, bond market investors have loaded up on US Treasury bonds while politicians bicker over raising the debt ceiling and the budget deficit. The world’s most cautious group of investors appears to be unconcerned.
A few months ago, bearish commentators argued that bond yields would spike as soon as the Fed ended its second round of quantitative easing (QE2) on June 30, reasoning that the central bank’s own purchases had artificially inflated the price of US treasuries.
But this theory hasn’t panned out. Since June 30, the yield on 10-year Treasury bonds has declined from 3.16 percent to 2.91 percent; investors stepped up their purchases of US government debt as the debate over the federal budget and raising the federal debt ceiling intensified.
US government bonds historically have been a safe haven for global investors in times of economic or political turmoil; one would expect Treasury bonds to rally in response to the EY sovereign debt crisis, especially with investors beginning to question Italy’s fiscal health. With a gross domestic product (GDP) of more than USD2.1 trillion, Italy’s economy is the largest of the fiscally vulnerable PIIGS (Portugal, Italy, Ireland, Greece and Spain).
That Treasury securities remain a safe-haven investment suggests that the bond market isn’t worried that the US will default on its sovereign debt.
The corporate bond markets also appear unruffled by the potential that the Obama administration and Congressional Republicans will fail to raise the federal debt ceiling–an event that would catalyze a credit crunch of an even greater magnitude and duration than the one that froze credit markets after Lehman Brothers declared bankruptcy.
Despite the media’s scaremongering about the battle over the federal budget, bonds issued by BBB-rated corporations yield slightly more than 5 percent–a bit higher than the 52-week low. US corporations also sold about $30 billion in bonds in the first half of July, a respectable showing by any historical standard.
I agree with bond investors. The Obama administration and Congressional Republicans will reach a compromise deal that increases the government’s debt ceiling and averts a default, though may simply kick the can down the road until after the 2012 election cycle.
However, the situation in Italy is a cause for concern. As I’ve written repeatedly over the past year, the size of Italy’s economy makes it the most important domino in the eurozone’s sovereign debt crisis. Bailing out the third-largest economy in the EU is a much taller order than providing assistance to Greece or Portugal.
For much of 2011, yields on Italian government bonds have suggested that the market saw only a modest risk of default. But the yield on Italian sovereign debt has spiked recently, while the price of credit default swaps on the country’s 10-year bonds has soared from less than 150 basis points to more than 300 since spring.
Despite the recent surge in yields on Italian government, the risk that the nation will default on its debt remains overblown. Although Italy’s debt-to-GDP ratio is 120 percent, in 2010 the government ran a deficit that amounted to 4.6 percent of GDP–well below Greece’s deficit of 10.5 percent of GDP or the US deficit of more than 9 percent of GDP. Italy is likely to implement a $65 billion fiscal austerity measure that includes both spending cuts and tax increases.
The package includes reductions to housing-related credits, additional payments for health care services and changes in the retirement age. If Italy enacts these measures, concerns about the country’s ability to service its debts should subside. The Italian government aims to balance the country’s budget by 2014.
Because Italy runs a smaller budget deficit than its troubled peers, any reductions in government spending won’t be as damaging to the domestic economy as those undertaken in Greece and Portugal. Moreover, whereas the Greece remains mired in recession, Italy’s economy continues to grow, albeit at a snail’s pace of roughly 1 percent per year. A growing economy leads to stable tax revenue, a huge aid to budget-cutting efforts.
I’ll monitor the Italy’s sovereign bonds closely in coming weeks. Look for a drop in yields on Italian government bonds to be a significant upside catalyst for stocks.
Amid all the negative headlines, there have been some positive developments on the economic front. US initial jobless claims fell sharply in the most recent week’s data, and the widely watched 4-week moving average of claims appears to be rolling over. This suggests that jobs numbers could improve in coming months.
Finally, 11 of the 13 S&P 500 companies that have reported second-quarter earnings managed to beat analysts’ consensus estimate. Ten beat consensus revenue forecasts. If corporate earnings continue to come in better than expected, it will begin to alleviate concerns about a major slowdown for the US economy.
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