Politics & Policy

Running for the Exits

Hedge funds are dumping Treasury bonds. Do they know something?

The wisest and most successful bond investor of all time, Bill Gross, has dumped his bond fund’s $150 billion investment in U.S. bonds. One should not ignore the importance of this event. The largest bond fund in America no longer believes that Treasury bonds are a good investment. Moreover, Gross is not alone. Blackrock, the world’s largest money manager, is now underweighting Treasuries overall and reducing the duration of the bonds it still holds. That means they are dumping their long-term bonds, which are the most sensitive to interest-rate changes, in favor of Treasury instruments that mature in a year or less. Other bond funds, such as the $20 billion Loomis Sayles funds, are also forgoing Treasuries in favor of high-yield corporate bonds. Virtually everywhere you look, from great investors such as Warren Buffett to insurance companies such as Allstate, everyone is dumping their long-term U.S. debt and either buying debt that matures in less than a year or moving their money elsewhere.

So who is still buying U.S. debt? According to Bill Gross, the “old reliables” — China, Japan, and OPEC — are still in the market for 30 percent of all new debt. The rest, however, is being purchased by the Federal Reserve. There is no one in else in the market. For the first time ever, Americans are refusing to purchase their own country’s debt.

Gross estimates that the “old reliables” are still good for $500 billion a year in purchases, and will be for some time in the future. This is pretty much the amount they’ve had to buy in the past to rebalance capital flows distorted by the U.S. trade deficit. Gross, however, may be wrong this time. Japan, needing to finance its reconstruction, is much likelier to be a net seller of U.S. debt, while China’s economy is slowing and actually ran a trade deficit in the last quarter. That leaves only one buyer of consequence — the Federal Reserve.

Researchers at Gross’s firm, PIMCO, estimate that in the last quarter, the Fed purchased 70 percent of all new Treasury debt. This is a disaster in the making. By printing new money to buy debt, the Fed is both holding interest rates artificially low and flooding the world with dollars. Fed purchases have lowered rates to the point where there was no room for further decreases. With no more upside potential to holding debt, investors are fleeing on the assumption that the Fed will soon exit the market, causing rates to rise dramatically. Such a rate rise lowers the value of all current U.S. debt: Who will pay $1,000 for a bond paying 3 percent when she can get one paying 5 percent? Anyone who wants to sell a $1,000 bond they already own is therefore forced to lower the price if they wish to attract buyers. No one holding any of the almost $10 trillion in U.S. public debt is getting much sleep these days.

When the Fed’s $600 billion QE2 buying spree ends, there will not be enough buyers left to purchase the $1.4 trillion in debt the administration has built into this year’s budget, at least not at current interest rates. Gross believes interest rates have to rise approximately 1.5 percent (150 basis points) to attract sufficient buyers. This may be optimistic.

The Fed is not only looking to stop buying new debt, it also wants to get rid of the nearly $1.3 trillion currently on its balance sheet. Absorbing $1.4 trillion in new debt, rolling over maturing debt, and simultaneously purchasing debt the Fed bought during its quantitative-easing forays is a lot to ask of the market.

Moreover, there is a real risk that bondholders who see the value of their assets fall will stampede for the doors. There are already signs that the smart money is looking for just such an event. Short sellers — those betting on a bond sell-off — pumped over three-quarters of a billion dollars into short positions in just the last quarter. This compares with a negative flow of short funds in the same period last year. If the short sellers are right, and there is a stampede, all bets are off. The bond-market bubble that the Fed’s purchases created will explode, likely setting off a renewed financial crisis.

Come June, the Fed will be in a bind of its own making. If it stops pumping money into the system, interest rates will increase, and not just on Treasury bonds. Mortgage rates will rise and business credit will become more costly. The recovery could be strangled in its infancy. If it keeps on buying bonds, however, it risks never being able to wean the markets off the equivalent of monetary crack. Worse, the flood of dollars will continue to drive down the value of the dollar, raise commodity prices, and propel global inflation.

There are already signs that inflation, while still subdued in the United States, is looking to break out. It has begun wrecking havoc through many areas of the globe, for example providing the catalyst for much of the upheaval in the Middle East. And when it strikes here, the Fed will be out of options. It will have to turn off the money pumps, raise interest rates, and batten down the financial hatches. The resulting recession will be long and nasty.

It is time to face facts. Spending is so out of control that Treasuries are no longer a safe haven for investors. The markets are saturated with U.S. debt and increasingly unwilling to absorb more. There is only one way out of this mess — cut spending, fast and deep.

Given that the Congressional Budget Office last week stated that the administration’s budget would raise the debt by $2.3 trillion more than the White House Budget Office claims, these cuts are going to hurt. They will probably hurt a lot. That is the cost of fending off a true catastrophe.

— Jim Lacey is the professor of strategic studies at the Marine Corps War College and the author of the forthcoming book The First Clash. The views in this article are the author’s own and do not in any way represent the views or positions of the Department of Defense or any of its members.


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