In a fascinating piece of recent economic research, two analysts at the Cleveland Fed ask why U.S. bond yields are falling when the interest rates of European sovereigns facing similar debt issues are soaring. Their answer is more disturbing than reassuring.
The trends piece by Cleveland Fed economists Pedro Amaral and Margaret Jacobson, titled “Why Some European Countries and Not the U.S.?” brings ample data to support the idea that current debt and deficit trends could qualify the U.S. for honorary membership in the PIIGS group of countries. Yet the spread in 10-year-bond yields between the U.S. on the one hand, and Spain and Italy on the other, has only widened as 2011 has progressed. Why should the bond markets treat countries with similar debt profiles so differently?
“The two most frequently cited possibilities are substantial differences across countries in either the ratio of sovereign debt to GDP or in the countries’ growth prospects,” the authors say. Yet they show that neither stands to reason.
Basket-case Spain’s debt is 49% of GDP, far less than the U.S. ratio of 73%, which is near that of Ireland (78%). Amaral and Jacobson anticipate an objection to this line of analysis: “Two countries may have the same debt-to-GDP ratio and have very different immediate financing needs.” But not so in this case, they say. Future financial obligations and average debt maturities of the U.S. look very similar to those of “EZP” (eurozone periphery) economies.
If debt-to-GDP doesn’t explain the wide divergence in bond yields, what about growth prospects? This one really stings. IMF data projecting future budget balances shows the U.S. should be worse off, considerably, than all the PIIGS five years from now. Our current budget deficit is about 10% of GDP, a ratio similar to Ireland’s and greater than that of the other PIIGS. In 2016, revenue and growth trends suggest that ratio will fall only to 6% of GDP, while the PIIGS’ will have achieved greater progress towards budget balance by then.
So if neither our debt nor deficit trends are more favorable than eurozone periphery nations, why does the bond market favor us over them? Amaral and Jacobson cite four possibilities: Firstly, the U.S. banking sector represents a smaller potential liability (8% of GDP) to the U.S. than those of the PIIGS (greater than 20% in each of them).
Secondly, people tend to buy the bonds of their own countries, so the U.S. has a larger base of bond investors and has the advantage of foreign central banks investing in our bonds for nonmarket strategic considerations.
A third reason is the “safe haven” factor: “With a large fraction of European sovereign bonds in trouble, U.S. debt has benefited from an increase in demand,” the authors write.
The fourth reason the authors cite, “credibility,” seems somewhat less credible: “The government pledges to keep the debt at a sustainable level and the Federal Reserve assures that it will not monetize away the debt.” While many might challenge those assertions, the authors explicitly compare the U.S. to the European Union, whose Maastricht treaty rules on debt and deficits lacked teeth. (And using an extreme case to illustrate the principle, they point out why investors would view U.S. commitments as more credible than Zimbabwean government promises.)
The authors conclude that “the market seems to think the U.S. government can solve its debt problems,” and they implore the U.S. not to betray that confidence.
But Amaral and Jacobson’s provocative analysis suggests a starker conclusion. Ordinary American households seeking to keep their money in investments with stable returns and moderate risk need to consider the fact that U.S. bonds–like the Oldsmobile commercial–are no longer their father’s safe investment.