A Bullish View on U.S. Treasuries

U.S. President Barack Obama signed into law (Politico) August 2 a bill allowing the United States’ $14.3 trillion debt ceiling to be raised, just hours before the nation was set to default on its financial obligations. The weeks of partisan wrangling in Congress, coupled with the ongoing threat (Reuters) of a credit rating downgrade, has made some international investors skeptical of U.S. treasuries, reflecting a wider shift in global bond markets (WSJ). But uncertainty (Bloomberg) over the U.S. deficit and a possible downgrade is offset by the fact that the country still has the world’s deepest and strongest financial markets, says Kent Hughes, a global economics expert with the Wilson Center. "If there’s a downgrade,  that would not have a major impact on the attraction of U.S. treasuries, which would continue to be viewed as the best bet," especially in light of the troubled euro, says Hughes.

How have the dynamics of global debt markets shifted as a result of the long-lasting impasse over a U.S. debt agreement?

They have not shifted that much. The global debt market has certainly been looking at the U.S. situation, but up until just the last three or four days, they behaved as if they assumed that the debt ceiling would be raised. There was a period of nervousness, but nothing that showed a dramatic difference in the bond market. That may be a product of the fact that there is on-again-off-again concern about Europe and the question of Greece. As a result of that uncertainty, you’ve seen a bit of a rally with the dollar, which is driven by [investors] looking for a safe haven. And that’s consistent with what you see with the Swiss franc, which is the one currency against which the dollar has not risen. What I would have expected--perhaps a great deal more uncertainty so far--has not really roiled the international financial system.

Why are some international investors pinpointing emerging markets, such as Brazil, as less risk-prone than so-called developed nations?

The debt issues of some of these emerging markets look less risky than some of the European debt issues do. So that is, perhaps, consistent with this long-term trend that was probably symbolized by George W. Bush’s decision to use the G20 as a forum for dealing with the global financial and economic crisis, rather than relying on the traditional G7 or G8. And going forward--take Brazil as an example, which has really been careful to manage its fiscal policy--if they continue to have a strong macroeconomic policy, the attraction of their debt will continue.

How do you see global risk spread out at the moment?

I don’t think Europe has completely dealt with its debt situation. While Greece continues to come in and out of the headlines, there was a flurry of concern about Italy, and continuing concern about Spain; Europe continues to be an ongoing question mark. Many analysts say there cannot be a [correction] until there is, perhaps, more significant private sector--meaning, in some cases, European banks--involvement in an adjustment of Greek debt. Let’s assume that Spain, Portugal, and Ireland all have dealt with their debt; they still have a structural challenge in that they have to be as competitive as Germany, or as the Nordic countries and France.

In the United States, there’s still a good deal of uncertainty about whether there will be a second vote [or new congressional battle] on the joint committee [the bipartisan congressional committee mandated by the new debt legislation to propose a comprehensive plan for further reducing the deficit over the next ten years], or there will be mandatory, across-the-board cuts. You have the likelihood of a continuing resolution that will be debated, and there’s an upcoming expiration of gas taxes at the end of September; they go into a trust fund which helps fund infrastructure spending. But there’s now a question mark about whether there will be a big congressional debate over what used to be a fairly routine increase. What offsets [the uncertainty] is that we still have the deepest financial markets, and they are still viewed as the strongest.

Do you think investors still see U.S. bond markets as being more stable than emerging markets, such as Latin America or China?

China has an inflation problem they are still wrestling with. In parts of the country, they have a housing bubble and a rising cost of living. China is going to increase food imports as a way of dampening the rise of the price of food. So you could see China, in attempting to deal with some of these things, slowing its growth a bit--although I don’t see China allowing its growth rate to slip below 8 percent. It’s more difficult to know exactly what investments would be there when you don’t have a convertible currency. The system is more opaque. You don’t have the same rule of law that you do in Europe, the United States, and many parts of Latin America.

With regard to Brazil, that looks like a more stable opportunity, but again, they have to keep their eye on both inflation and the fact the real has been pushed up by a good deal of foreign investment--some of it foreign direct investment, which will be good for the long term, but some of it portfolio investments that are really responding to the higher interest rates there. South Africa, which is a new BRIC country--China added it recently--I don’t think that’s a major investment opportunity. Russia is very much still a commodity exporter and would depend heavily on those markets. India has enormous long-term promise, but again doesn’t have the deeper markets that you would want. All things considered, there’s going to remain a significant demand for U.S. treasuries. PimCo [Pacific Investment Management Company, the world’s largest mutual fund], which had gotten out of U.S. treasuries, is now getting back into them, thinking that is a better long-term deal.

There’s been some speculation that if the United States was downgraded from its AAA status, there could be a move from the dollar as the world’s reserve currency. Is that on the horizon?

I don’t see it coming in the near term. The big alternative to the dollar was the euro--and that, right now, looks considerably less attractive. You could see many years in the future, twenty years in the future, if China were to continue to [grow] and if China were willing to allow its currency to be convertible and so forth, there might be a greater range of currencies in which you would invest. People certainly do invest in Swiss francs, but there’s just not enough of them to be an alternative to the dollar. If there’s a [credit] downgrade, that would not have a major impact on the attraction of U.S. treasuries, which would continue to be viewed as the best bet.

I think in the end that Congress will deal with the long-term fiscal challenge that we face. I’m not saying that a downgrade is a good thing--it’s not. And it would be an historic change that would certainly be a big symbol. But the bigger the symbol, the more the United States often reacts in a very positive way.

You think a downgrade might be an impetus for dealing with the long-term deficit issue?

I do. I would say even the threat of it has influenced the debate. My understanding is that representatives from the rating agencies were up on the Hill talking to people and saying why they might feel that had to make a downgrade. We’ll see what this "super committee" [mandated bipartisan congressional committee on the deficit] is like, what they come up with. Some people would like to see the "Gang of Six" [six Republican and Democratic Senators that proposed reducing the deficit by $4 trillion over ten years] appointed to the super committee, which would be a way of saying that they might have a conversation about a bigger long-run deal.

How has the debate over the debt ceiling affected the United States’  standing as a global leader?

In particular, the impression the world had--that we really had a special expertise in running financial markets--has been greatly eroded, and it has hurt the overall standing of the United States. But if we do the right thing, it will reaffirm our ability to come together as a country. We are certainly not the only power in the world, but we remain so critical to so many things that we have a chance to restore and rise above whatever diminishment, whatever tarnishing, has taken place.

What are the implications of Russian Prime Minister Vladimir Putin saying that the United States is a "parasite on the global economy"?

We have to look back and say that for really two decades--although we’re still the richest country in the world--we’re borrowing from the rest of the world. By 2006, we were borrowing 6 percent of GDP from the rest of the world, and then we did not use it in a sensible way. Often borrowing is the smart thing to do if you’re investing it in a smart way. But we were not; we were borrowing and we were consuming. So we have to look back and say: We need again to be a saving and an investing nation, and not just a consuming nation. We need to export more and we need to build and manufacture more of what we consume at home. Those are the big lessons that come out of an era in which we were just over-consuming. One of the things that made this recovery so difficult was that the consumer was over-leveraged, just as many of the banks were.