US government debt is rising rapidly and the economy has come to a virtual standstill because of the coronavirus. However, treasury yields have never been this low. Yet, real alternatives to treasuries as a safe haven investment have yet to emerge, according to Quentin Fitzsimmons.
The Fed’s ‘brilliant fire-fighting ability’ is to be credited for treasuries’ steady performance over the past weeks, says the manager of the T Rowe Price Global Aggregate Bond Fund. After two consecutive rate cuts in early March, the Fed was blamed for succumbing to White House pressure and bringing panic to markets rather than calm. That criticism, however, has disappeared.
‘Investors did not understand the rapid rate cuts and the restart of QE at first, but afterwards it turned out that the Fed was three or four steps ahead of the market in estimating the severity of this crisis,’ says Fitzsimmons.
In fact, by lowering interest rates so quickly the Fed anticipated the run on cash that would take place later in March, temporarily pushing yields back up again. ‘In hindsight, US interest rates have remained fairly stable all the time thanks to the Fed’s policy,’ he notes.
‘Fed will keep rates low’
So treasuries more than lived up to their safe-haven status thanks to the Fed’s resolute action. But will this continue to be the case? The yield on 10-year US government bonds has fallen to around 0.6% thanks to the Fed’s interest rate cuts, but the US budget deficit is rising while the economy may be in its deepest recession ever. The Congressional Budget Office predicted last month that the US public debt ratio will already exceed 100% by the end of this year.
‘It’s understandable if investors are concerned about the massive increase in government debt as a result of the corona crisis. And the tremendously rapid rise in unemployment shows that the US is indeed struggling to respond to this crisis due to the lack of a social security system,’ Fitzimmons notes. ‘But on the other hand, you see that in other countries as well. Budget deficits are skyrocketing everywhere.’
And then, of course, there’s always the Fed. It is determined to keep government bond yields at their current low levels. ‘And that’s possible, because in principle the Fed can buy US government bonds indefinitely,’ says Fitzsimmons. Moreover, yields can even go lower. ‘I don’t think the Fed is going to cut policy rates much more after the negative experiences in Japan and Europe, especially for the banking sector. But if inflationary expectations continue to fall, which is not inconceivable due to the shocks that are now also hitting the demand side of the economy, we could face negative yields in the belly of the curve, around maturities of five to six years.’ In the long term, the fund manager expects inflation to rise as a result of deglobalisation. This is a trend that has been going on for some time, but may be exacerbated by this crisis.
Reserve currency
The US has a large current account deficit and relies heavily on foreign financing of public debt. At the end of 2018, according to a US Congress report, 39% of US federal debt was in the hands of foreign investors, with China and Japan as the largest creditors. At the end of 2018, both countries each owned approximately $1000 billion in US government bonds. Should those foreign investors suddenly decide not to buy US government bonds anymore, the country would be in trouble.
But luckily for the US, that’s unlikely to happen for the time being. The dollar is still by far the most important currency in international trade. Also, a lot of debt, especially in emerging markets, is issued in dollars. This means that the demand for dollars, and therefore for American government bonds as the most important dollar instrument, remains high. ‘This is another reason why the US can afford large budget deficits and still pay a lower interest rate than one would otherwise expect,’ says Fitzsimmons.
Eurobonds
Are there really no credible alternatives to treasuries as an international safe-haven? Not really, is Fitzsimmons’ short answer. Eurobonds could in theory be such an alternative, but a mutualisation of eurozone debt is unlikely to arrive any time soon because of practical difficulties, the fund manager explains.
‘If Europe were to issue a form of common debt that partially covers the financing needs of a country like Italy, no one would want to buy Italian government bonds anymore. The good money will drive out the bad.’ In other words: investors will prefer Eurobonds over lower-quality Italian or Spanish debt, and yields on these bonds will skyrocket, he argues. ‘And in order for communal debt issuance to really take off, the European countries have to stand in for each other’s debt. This requires a transfer of power from sovereign countries to Brussels. That was always the idea behind the euro, but is it really happening? I’m not so sure.’
Chinese bonds then, perhaps? The country has only been included in international benchmarks since last year, and Fitzsimmons has an allocation of about 4% to the country’s bonds. ‘Chinese bond returns have been excellent this year, and yields are still at a relatively high level [of 2.5%]. But a handicap for Chinese bonds is the fact that the market is less transparent, and still only moderately accessible to foreign investors,’ he says.