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THE TREASURY BOND MARKET took a hit that was roughly comparable to a 200-point hit in the Dow Jones Industrial Average Wednesday when far fewer buyers than usual showed up for the U.S. government's sale of notes.
That this buyer's strike took place just a day after President Obama signed into law the sweeping reform of the American health-care system may have been just coincidence. Still, it is curious that the huge sell-off in Treasuries came against a news backdrop that might have been expected to boost the market, especially since it did send the dollar surging, indicating the world was bidding for U.S. assets.
European markets again were on edge after Fitch Investors lowered its rating on Portugal's debt by one notch, to double-A-minus, which made clear Greece isn't the only eurozone country with deficit problems. That sent the euro sliding anew, plunging to a 10-month low of $1.33, and in turn the U.S. Dollar Index sharply higher, to nearly a 10-month high.
All else being equal, Treasuries would be expected to be strongly bid as the result of the travails abroad and more soft economic data at home in the form of sluggish new home sales despite the heroic efforts to support housing through tax credits for buyers and massive mortgage purchases by the Federal Reserve.
Yet, Treasuries plunged, with the 30-year long bond shedding 1 24/32 in price, or $17.50 per $1,000 bond, which lifted its yield to 4.72%, back to the highs of the trading range going back to last summer. The benchmark 10-year note lost 1 6/32, pushing its yield up to 3.83%.
But Pimco's Bond King and Barron' s Roundtable member Bill Gross contends the relatively high yield on a 30-year bond (compared to a less than 1% on a two-year note) reflects the mounting unfunded obligations taken on by the U.S. government.
In his latest monthly missive, Gross notes the discounted present value of future social-insurance expenditures, mainly Social Security and Medicare, total $46 trillion. The passage of health-care reform will only add to that entitlement.
"No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office," Gross writes. "Common sense alone would suggest that extending health-care benefits to 30 million people will cost a lot of money and that it is being 'paid for' in the current bill with standard smoke, and all-too-familiar mirros that have characterized such entitlement legislation for decades."
In that regard, Gross cites an op-ed piece in Sunday's New York Times by former CBO director Douglas Holtz-Eakin, who wrote that rather than reducing the budget deficit by $138 billion over the next 10 years, health-care reform will add $562 billion to the deficit over that span. "Long-term bondholders beware," he warned.
The impact of entitlements is further underscored by another New York Times article Thursday, which reports that Social Security will pay out more than it takes in for the first time in 2010. That had been forecast to happen out in 2016, but rising unemployment has meant fewer workers paying into the system and more early-wave Baby Boomers receiving benefits.
One anomaly of the bond market's slide is that the yield on some top-grade corporate debt securities ducked under that of comparable Treasuries. That suggested that the credit of the U.S. government was being called into question. While the mounting quantity of U.S. debt from federal budget deficits is putting pressure on the market, that doesn't mean its quality is deteriorating.
To a journalist, that is an attractive story idea. It conjures up story leads along the lines of a recent story that asserted the bond market deemed Warren Buffett's Berkshire Hathaway (BRKA) a better credit than Uncle Sam.
"This is really idiotic," writes David P. Goldman, the former head of credit research at Bank of America on the Inner Workings blog at Asia Times (www.atimes.com.) "The Treasury has the power to tax. Corporations don't. If the Treasury runs short of money, who gets taxed? It's possible for corporate debt to trade through sovereigns, e.g., a Mexican multinational whose cash flow derives mainly from global operations."
Yet the press was abuzz with stories about "negative swap spreads." In which the fixed-rate portion of interest-rate swaps yielded less than Treasuries at the 10-year maturity point. But as Goldman explains:
"This is a purely technical artifact of the yield curve and the carry trade. Banks and corporations all want to pay floating [rates] and receive fixed [rates] because longer-duration fixed-rate cash flows pay something, and short-term debt pays a quarter of a percentage point or less.
"In the market for interest-rate swaps, there is massive demand to receive fixed-interest payments, which drives down the yield of interest-rate swaps. There is so much demand that interest-rate swaps in the U.S. trade flat to Treasuries. This happened in Japan during the 1990s for the same reason, when the Bank of Japan financed the huge government borrowing requirement through the carry trade.
"Add to this the fact that the Federal Reserve has bought over $1 trillion in mortgage-backed securities. Banks typically buy mortgages and hedge them with interest-rate swaps, that is, pay the fixed swap rate. By taking so much of the float off the market, the Fed has eliminated $1 trillion worth of demand for interest-rate swaps. That means the preponderance of demand is to receive fixed -- so swap yields fall.
"What matters to most of the corporate bond buying universe is NOT the fixed yield on corporate debt, but the spread above cost of funds once fixed-rate bonds are swapped into floating. With swap spreads at zero, high-quality corporate debt will trade below the swap yield, and thus below the Treasury yield," Goldman concludes.
For now, the fall of corporate debt yields below those of comparable Treasuries reflects credit-market technicals. But the sharp uptick in Treasury yields may indicate something more fundamental -- that the bond market cannot absorb an infinite amount of even U.S. debt without a price concession The passage of health-care provides a reminder of that simple fact.
Comments: randall.forsyth@barrons.com
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