LONDON (Reuters) - Worsening government finances, a fragile currency, rising interest rates and heightened political uncertainty? U.S. Treasury bonds’ status as the world’s ‘risk-free’ asset looks shaky and euro zone debt may offer an alternative.
Global investors looking to minimise risk — particularly those in Europe — have been steering clear of U.S. Treasuries in recent months, even while the interest rate gap between the United States and Europe has ballooned further.
U.S. debt levels, expressed as a percentage of gross domestic product, are on track to rise above those of Italy — long one of the world’s most indebted states — in five years, the International Monetary Fund warned last month.
With some $1.5 trillion in tax cuts and $300 billion in new spending planned by the Trump administration, the U.S. fiscal deficit is expected to widen sharply, possibly topping $800 billion next year, up from $665 billion in 2017.
And as the Federal Reserve’s balance sheet shrinks, rising supply of new bonds and higher interest rates risk making the U.S. government bond market more volatile.
In the euro zone, by contrast, debt levels and bond issuance are falling steadily, and once crisis-hit states such as Spain and Portugal are enjoying credit ratings upgrades.
Ebbing existential threats to the euro, steady economic growth and continued low borrowing costs are luring more foreign buyers to European bonds — year-to-date inflows are around $15 billion versus a fall of around $4 billion a year ago, according to EPFR Global data.
Japanese investors bought a record $2.57 billion of Spanish bonds in March.
“The world still needs havens, and if U.S. Treasuries are not doing what they say on the tin, the world will look for alternatives, and that plays into euro debt having a better ‘haven’ status,” said Barnaby Martin, credit strategist at Bank of America Merrill Lynch (BAML).
“For reasons of depth and liquidity, you still won’t be able to beat the U.S. Treasury market but it’s not the haven that it used to be.”
The $21 trillion U.S. government bond market is the world’s biggest and most liquid. The euro zone’s three biggest states, Germany, France and Italy, meanwhile, have a combined $8 trillion outstanding in government bonds.
But with all the additional borrowing being mooted, the United States is the only developed economy where the debt-to-GDP ratio will rise over the next five years, the IMF predicts.
(Graphic: U.S. debt dynamics weaken, reut.rs/2rvE0lp)
It projects U.S. debt levels to almost reach 117 percent of GDP by end-2023, from 108 percent at the end of 2018.
That brings the risk of credit rating downgrades — S&P Global has already warned of negative action unless Washington addresses its budgetary issues.
“U.S. debt dynamics are moving towards dangerous levels over the next several years,” said Said Haidar, chief executive officer of macro hedge fund Haidar Capital Management.
“As the U.S debt rises, we are likely to see crowding-out of private investment as well as foreign interest in funding the U.S. deficit begin to wane.”
Italy’s debt-to-GDP ratio meanwhile is forecast to fall to just below 117 percent by end-2023 from around 130 percent now.
Fiscal discipline there may be loosened by parties set to form the next government, but even that pales in comparison to what’s just happened in Washington, and the broader euro zone is structurally on a much sounder footing.
What’s more, the euro zone’s quarterly current account surplus averaged 1 percent of GDP for the three quarters ending in December, the highest of the euro era. That effectively means an excess of savings is flowing out of the bloc, a slight reversal of which could further boost flows into bonds.
Foreign demand for euro zone debt has been supported recently by its appeal on a currency-hedged basis, but investors are also reassessing their view due to ratings upgrades and stronger growth.
This suggests that during times of market turmoil, foreign investors have a wider choice of safe-havens than before.
Analysis by BAML may help explain this.
A decade ago, during the 2008 financial crisis, the correlation between Treasury and stock returns was significantly negative, at minus 60 percent, they calculate. Then, Treasuries acted as an effective safe harbour, with prices rising as equities fell.
Now though, that negative correlation is minus 28 percent, implying that Treasuries and equities are less likely to move in opposite directions.
But in the euro zone, bond markets such as Italy’s, typically viewed as risky, not only held their ground through the first quarter’s market turmoil but rallied in price — in other words, they behaved like “safe” assets should.
(Graphic: Bond safe havens but not as you know them, reut.rs/2rrhklU)
“You could argue that investors are more likely to look at (Italian) BTPs than USTs, which sounds extraordinary,” said Mizuho’s head of rates strategy Peter Chatwell. “That’s because of the low volatility environment the ECB has created through quantitative easing.”
U.S Treasuries are one of the poorest performing major bonds of 2018, with 10-year yields up 60 basis points US10YT=RR. Spain and Italy are among the best performing.
Craig Veysey, fund manager of the Sanlam Strategic Bond Fund, sees Italian debt as appealing, because ECB buying and high ownership by domestic investors makes it less volatile.
“That low volatility in some ways makes them less risky,” he said.
(Graphic: World bond market returns, reut.rs/2wHo4Bm)
Reporting by Dhara Ranasinghe; Additional reporting by Saikat Chatterjee; Graphics by Ritvik Carvalho; Editing by Mike Dolan and Catherine Evans