This week at Davos, Nouriel Roubini wondered aloud why bond vigilantes have not begun to sell off U.S. treasuries in light of a large and growing debt, suggesting that they are “asleep at the wheel.”
On the surface it appears to be a fair question, given U.S. government deficits that are nearly 8 per cent of gross domestic product and a debt-to-GDP ratio of over 70 per cent and climbing. But I will have to disagree with my colleague, affectionately known as Dr. Doom, as bond markets are acting perfectly rationally.
Countries are often punished by bond markets for failing to get their fiscal houses in order. When Canada was racking up large debts in the early 1990s, rating agencies downgraded our bonds, and the yields on Canadian bonds rose as investors were hesitant to hold our debt.
The risk to holding Canadian bonds was not so much a default, but rather that Canada would use the monetary printing press to pay for debt, causing a decline in a Canadian dollar. Since those bonds were denominated in Canadian dollars, foreigners investing in Canadian bonds were taking a significant currency risk.
The market for U.S. bonds is a great deal different than bonds from small, open economies like Canada.
The U.S. dollar is a major reserve currency, which reduces currency risk as bond investors will likely want to continue holding on to U.S. dollars after they sell their bonds.
The greenback is also less likely to be subject to large currency swings from the actions of international investors simply because the market is so large and so liquid. Canada does not provide the best comparison for the American situation.
Bonds denominated in U.S. dollars should be compared to those denominated in other reserve currencies, where the bond issuing country also has control over that currency.
This leaves anything denominated in the euro out. While the fiscal situation in Germany is relatively attractive, using the euro ties them to countries with large debt problems such as Greece. Given the United States controls their currency and Germany does not, Germany also does not make for the best comparison.
There are two other countries in the world that have reserve currencies, the United Kingdom and Japan.
The debt situation in the U.K. is not much different than the United States, with the latest estimates showing a deficit of nearly 6 per cent of GDP and a debt-to-GDP ratio of over 70 per cent.
Japan, on the other hand, makes both the U.S. and U.K. look like paragons of fiscal virtue, with the world’s largest debt-to-GDP ratio at 240 per cent. While the fiscal situation in the United States is unpleasant, it is strong in comparison to other large countries which control their own currency.
My question for Mr. Roubini is this: “If investors should sell U.S. bonds due to American fiscal problems, then whose bonds should they buy instead?”
Buying bonds denominated in euros is simply substituting one set of problems for another. The entire world cannot invest in mid-sized markets like Canada and Australia, as those markets are simply too small and yields have already been driven incredibly low.
Finally, if markets should be worried about government debt, Japan and the United Kingdom are about the last places you would want to invest.
Bondholders are following this old piece of wisdom: “Never abandon Plan A until you’ve developed a Plan B.” While the fiscal situation may be terrible in the United States, the alternatives do not look much better.