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New threats to bond markets

Created:
16 July 2008
Written by:
Chris Dillow

The US Treasury's proposed bail-out of Fannie Mae and Freddie Mac, the government-sponsored mortgage companies, could raise global government bond yields, economists fear.

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The Treasury has already promised the two companies a credit line of $300bn, and offered to buy shares in them. However, if this aid proves insufficient, the US government's liabilities could increase enormously - Fannie and Freddie have more than $5 trillion of debt. If the Treasury has to take over all this, the US's national debt would rise by over 50 per cent, equivalent to more than a full year's GDP. Stephen Bainbridge, professor at the University of California at Los Angeles, says that in the worst case scenario this would cause US Treasury bonds to lose their AAA status, triggering a mass sell-off. Given the close correlation between Treasuries and other government bonds, this would raise yields around the world.

Even if it doesn't come to this, the Treasury's move is bad for bonds in another way. It shows, says Alex Patelis, head of international economics at Merrill Lynch, that governments prefer to support growth even at the expense of inflation: "Policy-makers react very aggressively to downside surprises to growth, but very slowly to upside surprises to inflation," he says.

Another threat to Treasuries is that foreign buying of them could slow. Michael Pettis, professor at Peking University, points out that the growth in China's foreign exchange reserves is now slowing. And other economists believe high inflation will cause oil exporting Arab nations to revalue their currencies, requiring them to buy fewer US assets.

Investors who think government bonds are a safe haven from stock market volatility could therefore be in for a nasty surprise.

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