Will debt spotlight shift from Europe to US?

Last Updated: Dec 03, 2010, 09:36 AM IST

New York: Already rattled by Europe`s debt crisis, nervous bond investors may take aim at the United States next year, especially if political bickering frustrates efforts to cut the US budget deficit and hold down national debt.

The United States has unique advantages, including the world`s reserve currency and the ability to print it.

But Europe`s problems have investors reconsidering whether lending to developed countries is always a risk-free endeavor. Citigroup`s chief economist said this week the euro zone turmoil may be the "opening act" of a debt crisis that could even infect the United States and Japan, while a top Federal Reserve official said it was "a wake-up call" for America.

In that environment, US ailments -- a rising ratio of debt-to-gross domestic product, one of the highest peacetime budget deficits, strapped state governments, and banks that many fear are still "too big to fail" -- make investors queasy.

While the prospect of US default is remote, that doesn`t mean the United States will always be able to borrow money at less than 3 percent for 10 years, as it can today.

"Americans are kind of sleeping at the switch," said Joseph Quinlan, chief market strategist at US Trust and author of "The Last Economic Superpower." "Markets want to see we`re serious about tackling deficits. We should never be so complacent as to think the market won`t impose discipline on us."

Avoiding Sovereign

Higher borrowing costs haven`t been a problem for the United States in recent years. Since the onset of the financial crisis in 2007, yields across the curve have trended lower as investors took refuge in Treasuries, seen as safer than other assets in times of crisis.

The yield on the benchmark 10-year Treasury fell to a five-decade low in 2008 near 2 percent and has since not climbed above 4 percent even as US debt levels rose.

Ireland, by contrast, must pay nearly 9 percent to borrow money for 10 years, while Greece pays 12 percent.

But if market anxiety about sovereign debt in general continues to grow, some investors are bracing for US yields to rise next year. That could complicate efforts by policy makers to boost a struggling economy, lifting mortgage rates and interest payments on outstanding public debt, which at USD 9.3 trillion is more than 60 percent of Gross Domestic Product.

The Federal Reserve said last month it would buy USD 600 billion of Treasuries by the middle of 2011 to push long-term rates down.

And while lawmakers and policy officials have started to focus more on deficit reduction, suggestions for slashing the USD 1.3 trillion budget deficit from a bipartisan presidential commission have provoked strong criticism from left and right.

"I think markets will lose patience with gridlock," said Quinlan. "The market will sense it and you`ll see a lot of volatility."

Some say the US situation is not quite on par with the crisis in Ireland, which this week needed an emergency EU bailout to shore up its banks and slow a run on its debt. But some investors say it`s enough to make buying Treasuries risky.

"Our positioning has been to move away from sovereign debt" of all kinds, said Frances Hudson, global thematic strategist at Standard Life Investments, who said she prefers corporate bonds, equities and real estate outside the United States.

"The mantra we have is one of sustainable yield. We`re fairly indifferent as to where we get it, but it has to be sustainable," she said. "That`s not really what you`re getting from sovereign debt markets at the moment."

While Standard Life has on a USD 1.5 billion short euro/long dollar position in its $9.5 billion Global Absolute Return Strategies portfolio, Hudson said, "It`s less a positive call on the dollar than a negative one on the euro."

Hudson warned US growth could hit snags, particularly if US states require assistance from Washington similar to what Ireland and Greece have received from Brussels and Frankfurt.

Growing Out Of Trouble

The United States still has some things going for it, such as its ability to grow its way out of crisis.

Recent economic data has suggested aggressive federal spending and the Fed`s stimulative policies that have ballooned US deficits may also be helping the economy gain traction, at long last, after the worst downturn since the 1930s.

Tony Crescenzi, a portfolio manager at Pimco, the world`s largest bond fund, said absent no new spending initiatives, a 2.5 percent to 3 percent US growth rate in 2011 should chip away at the deficit, increase tax revenues and allow the economy to "muddle through."

While it won`t address longer-term issues like entitlement spending, he said the expected growth illustrates the differences with Ireland or Greece, which investors fear won`t grow enough to service or redeem outstanding debt or withstand planned spending cuts.

According to the latest Reuters poll, the US economy is seen growing at a 2.7 percent rate next year, up from 2.4 percent in 2010.

Richard Bernstein, chief executive at Richard Bernstein Advisors, said he is bullish on the US economy, stocks and the dollar, and he called the euro zone panic and worries about US public finances "vastly over-dramatized."

He said firmer US growth will relieve pressure to tighten fiscal policies too aggressively and may even allow the Fed to scale back its planned bond purchases.

"Long-term US interest rates are likely to rise next year simply because the economy is stronger than people think," he said. "It`s not because people fear the United States is turning into Argentina or Ireland or Greece."

The dollar also remains the world`s reserve currency, with no obvious alternatives for central banks and private investors to park their money.

But as the last few years have illustrated, market expectations and long-held maxims can change very quickly.

Simon Johnson, a former chief economist of the International Monetary Fund and a professor at the MIT Sloan School of Management, said he fears another US downturn could expose new problems at large U.S. banks, many of which the government rescued when the end of a real estate boom sparked a world financial crisis in 2007-2008.

If this happened a second time, he said, the foreign creditors on whom the U.S. relies may not be as willing to finance another bailout -- at least not at current rates.

"The market doesn`t think this is imminent, but just a few months ago, it didn`t see this coming for Ireland, either," he said. "That could ruin us just like it`s ruined the Irish."

Bureau Report

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