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Sovereign Bonds: The world’s shallowest cliff

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Rock-bottom yields and a poor debt outlook - brought into focus by the ‘fiscal cliff' - make US Treasuries a tough ‘safe haven' to love, finds Joseph Mariathsan

The sheer size and importance of the US Treasury market means that it cannot be ignored. But apart from US dollar bonds being a perceived ‘safe haven', is there any other reason for a rational, profit-maximising investor to look to the market?

The Towers Watson view, from head of investment strategy UK Alasdair Macdonald, is that yields are lower than justified by economic conditions.

"We expect yields will rise more than currently priced into the markets," he says. "We are not saying that clients should sell all their bonds, but slow down the pace of moving into bonds."

Combine all state and municipal debt together with US government debt, and the total debt-to-GDP ratio exceeds the 90% threshold that economists Carmen Reinhart and Kenneth Rogoff have identified as leading countries to significantly lower growth.

But as Dan Loughney, portfolio manager at AllianceBernstein, argues, whenever there have been concerns about debt in the US, there has always been some kind of intervention, most recently through quantitative easing (QE) keeping yields low in an effort to stimulate the economy.

For investors, the so-called ‘fiscal cliff' facing the US at end of 2012 has raised new concerns. If new legislation is not approved, Bush-era tax cuts will expire, leading to tax increases and spending cuts which could drive the economy back into recession. But the alternative of cancelling tax increases and spending cuts will add to the deficit. The Congressional Budget Office has warned that unless Congress acts, US GDP could shrink by 0.5 percentage points next year.

"I can't overestimate the importance of the fiscal cliff," says PIMCO portfolio manager Josh Thimons.

Jon Taylor, head of fixed income at Principal Global Investors, concurs. "Paul Ryan, Mitt Romney's running mate, is the patron saint of the Tea Party," he observes. "He has a religious zeal for fiscal conservatism. Because he has been selected, Republicans will take a harder stance than they would have done otherwise."

However, Thimons points out that the transmission mechanism to the real economy is not a short-term cataclysmic event like it was last summer when the US had the debt-limit debacle.

"The effects of the fiscal cliff are long-term in nature and we are just starting to see the effects now," he argues. "There is certainly anecdotal evidence of defence contractors and project managers restricting hiring and projects in anticipation of the fiscal cliff and concerns over future tax policy."

The brinkmanship of August 2011 could have led to the cataclysm of the US government defaulting on its debt. In contrast, the real economy is really where the effects of the fiscal cliff are evident and the issues are less about the knee-jerk reaction of markets: "The markets have been conditioned to the idea that Washington will not get it right and they will just kick the can down the road," Thimons reasons.

Where does the solution lie? "There needs to be a bi-partisan agreement on a long-term fiscal plan that addresses both sets of sacred cows," Thimons suggests. "Firstly the entitlement spending that is unsustainable over the long-term - with Medicare and Medicaid unsustainable even over the medium term; and secondly, tax reform."

The Simpson-Bowles plan produced by the Obama-established National Commission on Fiscal Responsibility and Reform, was such a compromise. It was initially shot down in the partisan deadlock with Paul Ryan, who sat on the Commission, voting against it. While the plan might have had its flaws, unless a bipartisan plan of some sort is agreed, the problems are likely to fester, since it is highly unlikely that either party will ever have a sufficiently large majority during the next Administration to be able to force through radical plans of their own against a hostile opposition.

Investors, both US and otherwise, face a future of ongoing uncertainty as the only compromise that has been reached is to delay both the entitlement debate and the tax debate that, as Thimons argues, is required to create a long-term strategy that does not create a drastic short-term fiscal contraction that will hamper the tepid recovery that the US is now experiencing.

Yet some investors clearly still have a requirement for US Treasury bonds. Short-dated bonds, with yields close to zero, may be fine for those looking to park assets in dollars for a safe haven; but few would argue that yields at the long-end give anywhere enough compensation for the huge inflationary pressures stoked up by the Fed's money printing. The US is likely to eventually show higher growth than Europe, but it is difficult to see 30-year government bonds yielding 2.75% (as at end August) offering positive real yields after the distortions of the marketplace caused by QE have been removed.

"There is no evidence of inflationary trends at the moment, but inflation is something that isn't going to announce its arrival," warns Thimons. "It is going to sneak up on you. Our base case is not for hyper-inflation, but inflation is certainly a risk factor. Because you have both unsustainable debt dynamics on the fiscal side and you have monetary policy in the land of the unknown, you can't rule out the possibility that inflation is on the horizon."

Not surprisingly, PIMCO is focusing on 5-10 years - the belly of the yield curve where it is steepest. But as Thimons admits, it is difficult to foresee capital gains arising from lower yields. "We are just running out of room for further yield declines. You want Treasuries for the carry and the roll-down potential. The Fed has provided a tremendous amount of support and their pro-activity is likely to continue for a long period of time."
 

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