Record low interest rates and record high debt levels are a marriage that history tells us won’t last long.
This is a lesson European bondholders have already learned. And it is one that will likely unfold in the U.S. Treasuries market, the supposedly safe haven from the panic gripping European bond markets these days.
In Europe, holders of sovereign debt have already seen how soaring debt levels crush bond prices. Bond yields soared to over 20% on Greek debt as bond holders were compelled to take a voluntary 50% haircut on the face value of their bonds.
While technically not a default, the 50% markdown of the value of Greek bonds is no different than a default for the country’s short-changed creditors. Even worse, since the markdown on the value of the bonds was voluntary, credit default swaps bondholders bought to insure against the risk of default offered no protection at all.
Looking at what happened to Greek bonds, it is not difficult for global fixed income markets to worry that Italian or Spanish bondholders will be soon asked to take similar voluntary haircuts. Both countries’ bond yields are approaching the 7% threshold that saw Portugal, Greece and Ireland exit the bond market and turn in desperation to their Eurozone partners for bailouts.
While Italy’s deficit is modest-sized, its debt is huge. It is the largest in the Eurozone, measuring in excess of the country’s gross domestic product. Should it or Spain require the same kind of assistance Greece, Portugal and Ireland have already received, markets fear the Reichstag will once again demand a pound of flesh from bondholders in exchange for further financial assistance from German taxpayers.
That may well explain the flight of capital from European bond markets, but it hardly justifies where the money has been fleeing. The flow of capital pouring into the U.S. Treasuries market pushed 10-year yields recently below two per cent.
But the debt laden U.S. Treasuries market is an unlikely sanctuary from Europe’s fiscal problems. The U.S. federal debt-to GDP ratio has almost doubled to 74% over the past couple of years.
And America’s debt ratio is only going higher in the near-term. With the so-called Super Committee in Washington striking out on a last minute bipartisan effort on a deal on future budget cuts, it is safe to say that America’s huge budget deficit isn’t going to be getting any smaller until after next year’s presidential elections. By that time, Washington will have just run up another trillion dollars or so of debt. That’s hardly a sanctuary from default risk.