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U.S. bond sales face market resistance

Section: Daily Dispatches

By Ambrose Evans-Pritchard
The Telegraph, London
Sunday, May 24, 2009

The U.S. Treasury is facing an ordeal by fire this week as it tries to sell $100 billion of bonds to a deeply sceptical market amid growing fears of a sovereign bond crisis in the Anglo-Saxon world.

The interest yield on 10-year U.S. Treasuries -- the benchmark price of long-term credit for the global system -- jumped 33 basis points last week to 3.45 percent on contagion effects after Standard & Poor's issued a warning on Britain's "AAA" credit rating.

The yield has risen over 90 basis points since March when the U.S. Federal Reserve first announced its controversial plan to buy Treasury bonds directly, a move designed to force down the borrowing costs and help stabilise the housing market.

The yield spike may be nearing the point where it threatens to short-circuit economic recovery. While lower spreads on mortgage rates have kept a lid on home loan costs so far, mortgage rates have nevertheless crept back up to 5 percent.

The Obama administration needs to raise $2 trillion this year to cover the fiscal stimulus plan and the bank bail-outs. It has to fund $900 billion by September.

"The dynamic is just getting overwhelming," said RBC Capital Markets.

The U.S. Treasury is selling $40 billion of two-year notes on Tuesday, $35 billion of five-year bonds on Wednesday, and $25 billion of seven-year debt on Thursday. While the U.S. has not yet suffered the indignity of a failed auction -- unlike Britain and Germany -- traders are watching closely to see what share is being purchased by U.S. government itself in pure "monetisation" of the deficit.

Don Kohn, the Fed's vice-chair, said over the weekend that Fed actions would add $1 trillion of stimulus to the US economy over time and had already prevented "fire sales" of assets.

"The preliminary evidence suggest that our programme has worked," he said.

The U.S. is not alone in facing a deficit crisis. Governments worldwide have to raise some $6 trillion in debt this year, with huge demands in Japan and Europe. Kyle Bass from the U.S. fund Hayman Advisors said the markets were choking on debt.

"There isn't enough capital in the world to buy the new sovereign issuance required to finance the giant fiscal deficits that countries are so intent on running. There is simply not enough money out there," he said. "If the U.S. loses control of long rates, they will not be able to arrest asset price declines. If they print too much money, they will debase the dollar and cause stagflation.

"The bottom line is that there is no global 'get out of jail free' card for anyone," he said.

The U.S. is acutely vulnerable because it relies heavily on foreign goodwill. China and Japan alone hold 23 percent of America's $6,369 billion federal debt. Suspicions that Washington is trying to engineer a stealth default by letting the dollar slide could cause patience to snap, even if Asian exporters would themselves suffer if they harmed their chief market.

The dollar has fallen 11 percent against a basket of currencies since early March. Mutterings of a "dollar crisis" may now constrain the Fed as it tries to shore up the bond market. It has so far bought $116 billion of Treasuries as part of its "credit easing" blitz, out of a $300 billion pool.

When the Fed first said it was going to buy Treasuries in March the 10-year yield to dropped instantly from 3 percent to near 2.5 percent, but the shock effect has since worn off. Any effort to step up purchases might backfire in the current jittery mood.

In the late 1940s the Fed was able to cap the 10-year yield at around 2 percent, but that was a different world. The US commanded half global GDP and had a colossal trade surplus. The Fed could carry out its experiment without worrying about foreign dissent.

Fed chair Ben Bernanke has long argued that central banks can bring down long-term borrowing rates by purchasing bonds "at essentially no cost." His frequent writings rarely ask whether foreign investors -- from a different cultural universe -- will tolerate such conduct.

Mr Bernanke is betting that under a floating currency regime there is no risk of repeating the disaster of October 1931, when the Fed had to raise rates twice to stem foreign gold withdrawals, with catastrophic consequences. This assumption may be tested.

It is not clear where the capital will come from to cover global bond issues. Asian central banks and Mid-East oil exporters have cut back on their purchases of US and European bonds as reserve accumulation slows. Russia has slashed its holding by a third to support growth at home. Even Japan's state pension fund has become a net seller of bonds for the first time this year as the country's population ages.

Japan's public debt will reach 200 percent of GDP next year. Warnings by the Japan's DPJ opposition party that, if elected this autumn, it would not purchase any more U.S. debt unless issued in yen is a sign that the political mood in Asia is turning hostile to U.S. policy.

There is no evidence yet that foreigners are in the process of dumping U.S. Treasuries. Brad Setser from the U.S. Council on Foreign Relations said global central banks added $60 billion to their U.S. holdings in the first three weeks of May.

This is bittersweet for Washington. It suggests that private buyers are pulling out, leaving foreign powers as buyers of last resort.

We just have to hope that G20 creditors agree to put a clothes peg on their nose and keep buying Western debt until the crisis passes, for the sake of the world.

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