The Message of Low Yields

05/31/2012 9:21 am EST

Focus: BONDS

Igor Greenwald

Chief Investment Strategist, MLP Profits

Amid a savings glut and a risk-taking deficit, the willingness to foster growth is what will separate crisis survivors from dead meat, writes senior editor Igor Greenwald.

Europe is coming apart at the seams, China’s laboring through a nasty slowdown, and the US economy limps toward the dreaded “fiscal cliff” with its flag drooping at half-mast.

And though the yield on ten-year Treasury notes hit a record low of 1.59% overnight, many Americans seem convinced it ought to be much higher, if the Fed would just stop pulling strings and let bond market vigilantes punish us for our big deficits. And then everyone could get rich off the interest on their savings account and live happily ever after, freed from the petty distraction of jobs and wages.

Unfortunately, all the bond vigilantes are currently busy in thrift-minded Europe, whereas on this side of the Atlantic their pictures are appearing on milk cartons alongside those of the small investor. Why should that be, considering that European deficits—even in places like Spain and Italy—are much smaller than our great lake of red ink?

Spain’s aiming for a deficit equal to 5.3% of its shrinking GDP this year (good luck with that) while Italy is targeting just 1.6% of GDP, though the International Monetary Fund rely expects something closer to 2.4%. Meanwhile, Uncle Sam is overspending by 8% of the pie, yet paying barely a quarter of the interest demanded of Spain and Italy.

People yelling that we’re the next Greece haven’t bothered asking why that might be—they just assume it’s the meddling Fed and dumb old luck that’s kept the wolves at bay.

In reality, the world’s awash with private savings as a result of the strong recent preference for hoarding rather than consuming. In the US, a growing proportion of the national income is being earned by multinationals and rich individuals who are unlikely to meaningfully increase their outlays. In places like Germany and China, the urge to save is deeply ingrained as a result of painful history and reinforced by government policies.

All that money has to end up somewhere, and Germany has encouraged a borrowing spree in Greece just as China funds dirt-cheap US mortgages.

Given this persistent savings glut, you would expect interest rates to trend lower even if the Fed was not out there buying long-term debt. And you’d expect the debt of functional economies to fetch a premium over that of countries being driven into depressions by outsiders preaching ill-timed austerity. It’s all about the return of principal rather than the yield, and those chances improve greatly for economies able to outgrow debt rather than shrink in its shadow.

That in turn means US bonds are in demand not because the Federal Reserve holds a lot of them, or will buy more, but because it has a credible commitment to promote growth even if Washington throws itself in front of the austerity train next year.

In contrast, the European Central Bank is charged solely with keeping inflation in line. So it is very credibly overseeing the European collapse, pending decisive action by politicians who can’t agree on anything.

The US economy has certainly been hurt by China’s mercantilism and concentration of wealth with those who needn’t spend, but at least it’s still a functional currency union. Which is to say that if the good people of Alabama and Mississippi continue to stint on education and health care, condemning more of their citizens to poverty, at least they can still count on a subsidy from richer California and Massachusetts, thanks to federal transfer payments.

This is a stabilizing mechanism that Europe sorely lacks, and in its absence the euro is strangling countries that can no longer afford it. And strangled countries don’t pay back their debts—it’s as simple as that.

The US may still throw itself over the cliff, but at least it’s not being pushed to the edge by powerful outside forces. This is what makes US debt attractive, alongside that of the UK and other northern European states as well as some emerging markets.

Like they, we control our own fate as long as we keep growing. Worrying about becoming “the next Greece” and undermining the Fed are good ways to put a stop to that—and to attract the wolves who live to pick off stragglers.

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