Bill Gross sees dangers in the debt-limit debate

The world's largest bond investor says the fight over raising the country's borrowing limit threatens to throw the debt market into a tailspin.

"It's the wrong way to do it," says Bill Gross, manager of the $241 billion Pimco Total Return Fund, the largest mutual fund. "Obviously, I'm all for a move to a balanced budget over time. But this is like imposing the death penalty for shoplifting."

In arguments over lifting the federal government's $14.3 trillion debt limit, both sides have used bond investors as a bogeyman.

Congressional Republicans say bond investors will set off a Greek-style financial crisis in the U.S. if the national debt grows. They've promised not to raise the limit without deep spending cuts.

The Obama administration says if Congress refuses to raise the debt ceiling in time bond investors will flee U.S. debt and create a larger meltdown than the last one.

And why do governments care what Gross thinks? Because bond buyers like him are essentially bankers to the world, playing a vital but behind-the-scenes role in the global economy. Any country that spends more than it receives in taxes relies on them to make up the shortfall. Deeply indebted governments can easily fall into a crisis when investors like Pimco turn on them.

Under the current limit, the government can borrow another $234 billion, a ceiling that could be reached as early as March. Lifting the limit is usually a non-event: Congress has raised it 74 times in the past 70 years.

This time, however, the battle could turn fierce. Republicans took control of the House in November on a pledge to cut the national debt, which ballooned because of a decade of budget deficits and the Great Recession. The Congressional Budget Office said Wednesday that this year's budget deficit will reach a record $1.5 trillion.

In response to President Obama's State of the Union address Tuesday, Paul Ryan, the new Republican chair of the House Budget Committee warned of "a crushing burden of debt" and drew comparisons to the European financial crisis.

Gross and others say the Republican strategy is reckless. Typically, bond investors are fiscal conservatives who want the U.S. to cut its debt and tighten its budget deficits. They worry that rising interest payments will swallow a larger share of the country's income and hurt the economy. But bargaining over the debt-limit vote raises the specter of a government default, and few things scare investors more.

"The signal it gives to countries that hold Treasurys is that their assets are hostage to a rogue Congress," Gross says. "That's the message it sends. It's unacceptable."

The real danger comes if the fight drags on. Pimco and other money managers have been selling Treasurys in recent months. The market took a fall in December after the Obama administration and Republicans reached a deal to extend Bush-era tax cuts along with unemployment benefits. The total package is expected to add $400 billion to the current year's budget deficit.

At a meeting of Pimco's investment committee last week, the assembled money managers agreed that the closer the government gets to the ceiling, the greater the risk that nervous investors will ditch Treasurys en masse. That would push long-term interest rates higher and risk derailing the economic recovery.

"The Treasury market will sell off as this get more press and with more invective," Gross says. "Investors like us, we sell now."

Bond investors are creditors, like banks. When investors buy a Treasury note, they lend the government money in exchange for a promise to return it later with interest. And like other lenders, they take a keen interest in a borrower's ability to pay them back.

The trouble starts when bond buyers worry that a country could default. That leads them to demand much higher interest rates for borrowing. Last year, cash-strapped Greece was essentially locked out of the bond markets because it couldn't afford the high rates. Greece avoided a default thanks to a 110 billion euro bailout by the European Union and International Monetary Fund last May. Greece needed bond investors to keep it afloat, but bond investors didn't need Greece.

In contrast, U.S. government bonds and the dollar underpin the global financial system. The Treasury yield is used as a benchmark for all borrowing, a point of comparison for debt around the world. A default on U.S. government debt would cause unthinkable chaos, says Rich Tang, head of fixed-income, equity and foreign exchange sales at the RBS Securities. The dollar would fall and credit markets would seize up around the world.

That's the main reason why few believe the U.S. will miss an interest payment. If Congress fails to raise the limit, the Treasury has a number of cash-management tricks that could delay a default for a few months. If that fails, analysts believe the government is more likely to stop making Social Security payments to Americans than miss an interest payment to China.

The Treasury took a pre-emptive step on Wednesday to head off a cash crunch. Starting next week it will gradually decrease the $200 billion the government has borrowed in a special program for the Federal Reserve, lowering that amount to around $5 billion.

Some bond investors support the Republican effort. Congress would be unlikely to tackle the budget deficit any other way, says Eric Stein, portfolio manager at Eaton Vance Management. Eventually, Democrats and Republicans will reach a compromise on spending cuts, he says. The end result: "You actually make fiscal progress."

Even an extended brawl that drives up Treasury rates could have benefits, Stein says. Higher rates would force Congress into taking budget-cutting seriously, much as higher bond yields in Portugal and Ireland led governments to push through austerity packages. "One reason we're so complacent in the U.S. is because are yields are so low," he says.

The closest parallel to the current standoff started in 1995 between President Bill Clinton and Republicans in Congress. The federal government shut down for 26 days over three months because the two sides failed to pass a budget. That caused antsy investors to dump Treasurys, sending the yield on the 10-year Treasury note swinging from 5.52% to 6.46%.

A public backlash helped Clinton win re-election in 1996. That experience should give Republicans pause, says Joseph Balestrino, fixed income strategist at Federated Investors.

"Republicans are making a stink because they feel like they have public support," he says. "But you don't hold this hostage. Nobody wins."

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