Monty Pelerin's World

Bond markets are looking askance on the Federal Government and its continuing profligacy. The belief that the US can continue to finance its current deficits may be questioned. According to Chris Wood writing for Casey Research, Warren Buffet (and other private firms) now borrows at a lower interest rate than Barack Obama: “At the federal level, we can see that the bond market is growing increasingly wary of the government’s spendthrift and “kick the can” attitude.”

Government having to pay more for its debt than private firms goes against accepted beliefs. Economics and finance students are taught that Federal government debt is risk-free. In empirical work, Treasury bill rates are used as a proxy for the “risk-free” rate of interest. How can something that is presumed risky, pay lower interest rates than something that is “risk-free?” It cannot! Treasuries are now starting to be perceived as higher risk than high quality private debt.

I have argued elsewhere that the federal debt problem is intractable and will result in defaults. It appears as though bond markets are starting to recognize this default risk.

It is likely that the risk premium continues to widen on government debt. If so, government spending increases very rapidly as interest rates are forced higher. 40% of government debt is short-term, rolling over within a year. If this is rolled over at much higher interest rates, interest costs for the government expand the already-huge forecasted deficits.

Ultimately this house of cards must collapse. Interest rates might be suggesting that such a change is coming sooner rather than later. Markets, once they have made up their minds, act brutally fast.

Who would you prefer to lend your money to?

Bond Market: “It’s Safer to Lend to Buffett than Obama”

By Chris Wood, Casey Research

A few weeks ago, the Federal Reserve released the new Z.1 Flow of Funds document, which covers flows and outstandings through the fourth quarter of 2009.

What does the document reveal?

You guessed it – more of the same reckless behavior that got us into this mess in the first place. While households and businesses were able to shed debt across the board, increases in local, state, and federal debt outstanding were enough to bring total debt outstanding to a new all-time high, over $34.7 trillion, if you can believe it.

Consider some of the salient statistics from the Z.1 document:

• Total household debt outstanding shrank by an annualized 1.2% in the fourth quarter, while total business debt outstanding declined at a 3.1% annualized clip.

• Combined, total household and business debt outstanding fell to $24.535 trillion, reflecting an annualized decline in the fourth quarter of 2.1%.

• State and local government debt outstanding climbed by an annualized 4.7% in the fourth quarter, while federal government debt outstanding increased at an annualized rate of 12.6%.

• Combined, state, local, and federal government debt outstanding grew to a record-breaking $10.168 trillion, reflecting an annualized increase in the fourth quarter of 10.7%.

So, while consumers and businesses are acting at least somewhat more responsibly, governments at all levels grow more reckless every day. And don’t think this has gone unnoticed by others.

At the federal level, we can see that the bond market is growing increasingly wary of the government’s spendthrift and “kick the can” attitude.

A March 22 article from Bloomberg titled “Obama Pays More Than Buffett as U.S. Risks AAA Rating” reveals that two-year notes sold in February by Warren Buffett’s Berkshire Hathaway yield 3.5 basis points less than Treasuries of similar maturity.

While 3.5 basis points is not a huge amount (100 basis points equals one percentage point), the simple fact that the bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama is telling.

And Buffett is not the only one enjoying this safer than “risk free” rate on his notes. Procter & Gamble Co., Johnson & Johnson, and Lowe’s Cos. debt also traded at lower yields than Treasuries of similar maturity in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey called an “exceedingly rare” event in the history of the bond market.

Rare as this situation may be in historical terms, we expect to see lots more of it in the future.

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