LISTEN TO ARTICLE 4:26 SHARE THIS ARTICLE Share Tweet Post Email

Photographer: Andrew Harrer Photographer: Andrew Harrer

Go inside the global economy with Stephanie Flanders in her new podcast, Stephanomics. Subscribe via Pocket Cast or iTunes.

America’s budget deficits are often described by economists as a problem. In the markets right now, they look more like a solution.

Even investors who worry about President Donald Trump’s loose fiscal policy are finding other things that worry them more. From China’s credit bulge to the European slowdown, warning signs are flashing globally. At home, the economy’s expansion is about to set records for longevity –- a reminder that it won’t last forever.

When that kind of foreboding takes hold, it translates into demand for safe assets. And Trump is supplying them -- at a pace of about $1 trillion a year, matching the projected shortfalls in the U.S. budget.

Into the Red Actual and projected U.S. budget deficits Source: U.S. Treasury, Congressional Budget Office

“When people are afraid of something bad happening around the world, they typically go for buying Treasuries,’’ said Thomas Wacker, head of credit in the chief investment office at UBS Global Wealth Management, which oversees about $2 trillion. Right now, “there are so many things cooking everywhere,’’ he said. As a result, “there’s a constant flow into dollar debt.’’

‘...Or Is It?’

The appetite is sharpened by the fact that U.S. government bonds -- unlike many of those issued by other stable, developed countries –- actually offer a positive yield. It’s a meager one by historical standards, but at least it doesn’t start with a minus sign. Trillions of dollars of debt in Europe and Japan has negative yields.

Better Than Nothing Average yield on 2-year government bond since start of 2019 Source: Bloomberg

Then there’s the extra scrutiny that comes when investors sense trouble ahead, and start asking: What’s truly safe, and what’s just mispriced? After all, much of the private, asset-backed debt that crashed the U.S. financial system and then the world economy a decade ago received top marks from the safety inspectors at credit-rating companies.

“People did think last time, before the crisis, that they had bought safe assets,’’ said Andrew Milligan, head of global strategy at Aberdeen Standard Investments. “Then they realized those assets were less safe than they thought.’’

Milligan thinks the same kind of doubts may start to creep in again, and gives an example. “Italian bonds today, how safe do you regard them? It’s a G-7 country, has almost the same yield as the U.S.,’’ he said. “It’s a safe home, surely... or is it?’’

In Lockstep Now… ...but they weren’t always Source: Bloomberg





Sovereign Pile

One reason to think Treasuries are safer is that they’re backed by a government that controls its currency and so can always meet liabilities denominated in dollars. That’s not the case for Italy, which is a user of the single European currency rather than an issuer of its own.

The distinction was vividly illustrated during the euro crisis early this decade. Yields on Italian bonds spiked above 7 percent, amid concern that the country could follow fellow euro-member Greece into default. They only subsided after the European Central Bank improvised a backstop.

Economists, meanwhile, were puzzling over the contrast with Japan, which appeared to suffer from the same fundamental problems as Italy: slow growth, high debt, stagnant demographics. Yet with its own currency and central bank, it had no trouble financing deficits at low interest rates.

Over the past decade, this has proved true for the U.S., too -– and for other currency-issuing governments in the developed world, like the U.K., even as their growing national debts cause alarm among fiscal hawks.

Who’s Borrowing? Percentage change in debt as share of GDP under low-rates regime Source: IMF, Bank for International Settlements

‘Peculiar Phenomenon’

Some analysts see it differently, pointing out that investor demand for safe assets drove a lot of the financial innovation that blew up in 2008. In other words, if there’d been more government debt back then, there would have been less need for exotic and unstable securities engineered to look like they were just as solid as Treasuries.

“It’s an argument a lot of people made for why the financial crisis was so severe, and the recovery after was so slow -- because there was a lack of safe assets,’’ said J.W. Mason, a fellow at the Roosevelt Institute in New York who focuses on the history and politics of American debt. “When the government spends money and borrows money, it’s creating safe assets. That’s the thing that’s being missed.’’

There are long-term reasons why investors want more of those assets -- aging populations that need more retirement savings, for example. Add in the short-run jitters about another recession or market slump, and the effect has so far been strong enough to confound a widespread belief that when deficits widen and more bonds go on sale, yields must rise.

“As and when the U.S. Treasury market explodes due to more issuance, you’ll be seeing a lot of investors simply dashing for safety and buying that debt,’’ said Milligan at Aberdeen Standard.

“Supply often creates its own demand in the bond market,’’ he said. “It’s a peculiar phenomenon.”