U.S. government bonds looked vulnerable last month, but the flight to quality is back.
The Greek bailout fiasco of the past few weeks has put a cork in the talk about U.S. interest rates imminently going through the roof.
The rate the government pays to borrow for 10 years has dropped sharply over the past month as worries about Europe’s stability returned to the fore. The U.S. 10-year yield rose above 4% for the first time in over a year in early April, but it has been dropping steadily since then and hit 3.61% Tuesday — near its low for the year.
Obviously, this is neither a ringing endorsement of the health of the U.S. economy nor a sign of fiscal restraint breaking out in Washington. Among other things, it’s a sign of how wildly mispriced the government bond markets seem to be, even as a new outbreak of Greek disease sends bond yields higher in places like Greece, Portugal and Spain.
Take Spain, for instance. Its 10-year bonds were yielding 4.08% Wednesday. That is just 36 basis points above comparable Treasurys — in a nation where one in five workers is jobless and where the banks still face staggering loan losses from the housing bust.
But bond investors aren’t the only ones to whom complacency poses a grave danger. A note Monday from Bank of America economist Ethan Harris projects that the federal deficit will come in at $1.17 trillion for fiscal 2011 – up from a previous forecast of $825 billion, thanks to ongoing stimulus spending and the Obama administration’s decision to hold the line on the Bush tax cuts.
If Congress can’t get its act together and come up with a plan to raise taxes and cut spending, Harris suggests, the U.S. could get its own visit from the bond vigilantes, which would raise borrowing costs and make budget problems even more severe.
He expects the 10-year yield to rise to 4.25% by year-end but fears worse down the road.
“In the current hyper-partisan political environment in Washington, D.C., the risk remains that only a crisis will force the compromises necessary to appropriately deal with the deficit problem in an economically sound manner,” he wrote. “One can only hope that the recent turmoil in Europe will strengthen the backbone of U.S. policy makers to fashion a solution before the cost of inaction rises even further.”
