Treasuries have turned anything but risk-free
By John Plender
Those who can diversify out of US debt are likely to do so
The US debt ceiling imbroglio may not have resulted in sovereign default, but I suspect that the rise in US Treasury yields from early summer until the temporary resolution of the crisis last week may in due course be seen as reflecting the emergence of a risk premium.
An important message of this episode, in other words, is that the world’s main reserve currency is now a very unsafe haven, while US Treasuries are anything but risk free.
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That, in turn, raises the question of whether the US is inescapably in decline as China rises to challenge its hegemony. Even without default it is clear, in purely financial terms, that anyone who can diversify out of US Treasuries will now feel impelled do so as far as possible.
Nothing could demonstrate more clearly how quickly politics can subvert the thrust of economics.
A mere month ago the US looked the only economy in the developed world close to achieving escape velocity from the crisis, as well as having an underlying dynamism conspicuously absent from Europe or Japan.
Yet the government closure seriously undermined its credibility in economic policy making while imposing a needless drag on growth.
The inability of the US to intervene in Syria has also raised questions about its ability to deploy hard power around the world. At the same time it has shown that its claim to act as a responsible custodian for more than 60 per cent of the world’s official reserves is tarnished.
The first exhibit on that score is the recklessness displayed by American politicians over the country’s credit rating. They have given the strongest possible hint that the degree of polarisation in Washington guarantees that fiscal punch-ups will be recurring events.
Nor is fiscal policy the only problem. Seen from the perspective of central bank managers of official reserves, quantitative easing constitutes dangerously experimental monetary policy for a country entrusted with $6.8tn of such reserves.
For emerging market countries, printing money via QE looks like a policy of competitive devaluation, even if it was embarked on for domestic reasons. And they have an understandable fear that exit from QE, which is the most experimental part of the experiment, will saddle them with even more seriously overvalued currencies along with higher interest rates on their foreign indebtedness.
It is also worrying for reserve managers that the Federal Reserve is operating in a fog. This is not just a matter of the impact of government closure on economic statistics, which will delay any retreat from QE. Nor is it purely about the lack of a route map for the exit.
The global financial system is hostage to a big rise in borrowing costs when the retreat from QE puts an end to the current era of extraordinarily low interest rates.
The rise in bond yields will thus inflict big capital losses on bond holders. Neither the Fed nor anybody else can know how those losses will be distributed around an increasingly complex system. How far bonds have been hedged or leveraged is likewise unclear.
Don’t believe central banks
Of course, the central bankers’ response is that the prudential regulators are well aware of the risks and will be on the alert. That is the same message they peddled back in 2008 when they were hopelessly wrong footed after the collapse of Lehman Brothers. Believe it at your peril.
So is there a parallel here with the transfer of hegemonic power from the UK to the US between the wars?
Yes, to a degree, but the differences are important. The UK was far weaker economically after the first world war than the US is today. The current crisis in the US is more political than economic. And it has to be said that American politicians are doing their utmost to speed up the transfer of power from the US to China. Yet where reserve currency status is concerned, it will take time for China to offer the world a credible reserve currency, not least because its financial markets remain under-developed.
As I argued here two weeks ago, the obvious message for Beijing is to accelerate the pace of financial market development. It will be interesting to see whether the communist party plenum next month unveils plans to do this.
Yet when contemplating blunders on the scale the US has just inflicted on itself, it is easy to underestimate the problems of strategic rivals. The challenge for China in its proposed liberalisation of interest rates and opening up of the capital account is quite as great as the exit from QE will be for the US.
Even so, declinism is now in fashion. It is safe to predict that this will be the global publishing business’s next growth industry.
The writer is an FT columnist
Treasuries have turned anything but risk-free