The Collapse of Sovereign Government Bonds The Next Financial Crisis Contagion

The next contagion is beginning to spread around the globe.

It is unexpected on Wall Street, misunderstood in Washington — and very dangerous.

It could sabotage the plans of the U.S. Treasury, the Federal Reserve, and many of their counterparts overseas.

It is …

The Collapse of Sovereign Government Bonds

This is certainly not the first financial contagion of recent memory:

Back in 1997, we witnessed a currency contagion —hatched in Thailand, spreading quickly to the rest of Southeast Asia … smacking Russia in the gut … and sinking a major player in the U.S. derivatives market.

Then, 10 years later, came the debt contagion —incubated in a subsector of America’s mortgage market … soon infecting nearly all credit instruments … striking Wall Street like a sledgehammer … and mortally wounding the global financial system.

Those contagions were bad enough. Now, however, the contagion is beginning at a much higher level, in the most important financial instruments on Earth — long-term bonds issued by sovereign governments.

The Saga Begins in Greece

Just 116 days ago, on October 8, Greece’s benchmark 10-year bond was selling for 112.295. Today, it has collapsed to 92.13.

And the drama of its yield surge is even more striking — from only 4.41 percent to 7.14 percent, a jump of more than 60 percent in less than four months.

Coincidentally, I was in Greece not long ago, visiting the origins of Western democracy.

If a local soothsayer had told me that the next global debt contagion would begin there, blocks away from the Pantheon, I would have been incredulous. Yet that is precisely what has just happened in recent weeks.

Already, this contagion is spreading to other countries …

Portugal’s 10-year government bond reached a peak on December 1, 2009, just 62 days ago. And now it has also started to plunge virtually nonstop, with its biggest declines registered late last week.

British government bonds (gilts) are equally vulnerable.

Sovereign bonds in Spain, Japan, and other major deficit nations are also starting to get hit.

Next Victim: U.S. Government Bonds

In the global competition for investor funds, U.S. Treasuries are typically viewed as the “least ugly.” So global investors have usually been willing to pay a relatively higher price for them, grudgingly accepting lower yields.

This helps explain why U.S. government bonds have not been among the first targets of the contagion. But that does not protect them from becoming one of the next targets.

Indeed …

The U.S. government suffers from the same, or worse, underlying disease as Greece, Portugal, or any other victim of the contagion — massive, out-of-control federal deficits. America’s red ink was $1.4 trillion last year and ANOTHER $1.4 trillion this year.

Washington has buried its head in the same mound of sand as Athens and Lisbon — grossly underestimating (a) the size of the deficit, (b) its potential impact on investor confidence, and (c) the speed by which its bond prices can fall.

Like his counterparts in Athens and Lisbon, President Obama ignored advisors who warned of a deficit disaster and has only just begun to seriously consider deficit-reduction measures. And yet he continues to avoid steps that can make a significant difference.

Specifically …

The president supports a commission to study deficit reduction (rejected by the Senate last week) … but the commission’s recommendations would be nonbinding with no clear process in place for implementation.

The president has proposed a freeze on some domestic spending, but the freeze will impact only a small portion of the budget, would not kick in until next year, and would include a mix of spending cuts and spending increases. It would have zero impact on the 2010 deficit and little impact on future deficits.

The president has promised to give TARP funds back to taxpayers, but has also proposed applying unspent TARP money to community bank lending — another lost deficit-reduction opportunity.

The president supports “pay as you go” rules for Congress — requiring new spending to be balanced against spending cuts or revenue increases. But the devil is in the details. If the rules have no truly sharp teeth, they will be ineffective.

My view: If the deficit was just $200 billion or even $300 billion, I might support and even applaud these small steps.

But in the context of back-to-back $1.4 trillion deficits and in the face of a looming bond market collapse, they represent barely more than too-little-too-late tinkering.

The Consequence of This Complacency Is Catastrophe

Sadly, although most advisors on the Obama team are now more conscious of the rising political tide against Washington bailouts and deficits, they not yet see the approaching tsunami arriving from Greece.

Money and Markets’ Mike Larson explains the situation this way:

“Imagine what would happen if Uncle Sam’s borrowing costs shot up like they have in Greece — by 60 percent! Imagine what that would mean for the cost of car loans, mortgages, and other products whose rates track Treasury yields! And imagine the impact on an economy still struggling to recover from the Great Recession! This is the next big story that few people are talking about.”

He’s right and he has been warning about it tirelessly.

But, alas, unless the Obama administration and Congress can somehow ax the budget or find a new gusher of revenues — both extremely unlikely anytime soon — collapsing U.S. bond prices and sharply higher long-term interest rates are unavoidable.

Like we saw during the contagions of 1997-98 and 2007-09 …

Confidence in vulnerable investments — this time, long-term U.S. government securities — will suddenly collapse. Then, it was certain geographical regions or market niches. Now it’s threatening the CORE of our national essence.

Investors will yank their money out in great haste …

The avalanche of selling will drive ALL bond prices — government, corporate, and municipal — into an uncontrollable swan dive. And …

The contagion will spread to any country on the planet that has the same obvious vulnerability to the disease — massive federal deficits.

There is, however, one outstanding silver lining in this new crisis: Sinking government bond prices — bringing surging costs for government borrowing — are the single most powerful market mechanisms for persuading governments to end their print-and-spend madness.

Provided we don’t fall again for the false promises of politicians — and provided we are willing, as a nation, to make the needed sacrifices — there IS still hope for America.

That’s one reason I don’t recommend you abandon the safety of Treasury securities. Rather, all along, I’ve made it clear the real concern is not with ALL Treasury securities. It’s strictly with longer term Treasuries.

The other reason is that shorter term Treasury notes (under a couple of years in maturity) are far, far less vulnerable than the longer term variety.

And U.S. Treasury bills (always shorter than one year) suffer virtually no price declines, even in the midst of a bond market collapse.

So stick with them. Yes, I know. Their yield is miserably low. But they still provide the world’s best safety and liquidity.

Just make sure you avoid all longer term notes and bonds — whether government-issued or not. When the market price of bonds declines, so does your principal value. And because of that loss in principal, any extra interest they might pay you could be wiped out in a heartbeat.

Good luck and God bless!

Martin

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