Why the alarm bells are growing louder over mounting US debt: Maley

The alarm bells over soaring US debt are growing increasingly shrill, with the world’s largest bond fund building up a short position in US Government bonds, while a former adviser to China’s central bank has labelled the US Treasury market a “giant Ponzi scheme”.

In an article published on the website of Chinese publication Caixin, Yu Yongding a former member of the People’s Bank of China monetary policy committee, and now a member of a state-run policy group, argued that US bond prices have been kept artificially high because of buying by the US central bank. Eventually, he said, bond prices would fall to levels that reflected the country’s economic fundamentals.

China has long worried that its vast hoard of US Treasuries is being eroded by the falling US dollar. China is the largest foreign creditor to the US, holding $1.16 trillion in US Government bonds at the end of last year.

Meanwhile, PIMCO, the world’s largest bond fund is betting that the US Government’s ballooning deficits will cause US bond prices to fall, pushing up the country’s cost of borrowing.

As a result, PIMCO cut its holdings of long-term government debt to “-3%” in its flagship $236 billion Total Return Fund in March. This compares with zero holdings in February and 12% in January.

At the same time, the fund has boosted its investments in cash and equivalents to 31% of total assets, up from 23% in February.

In his latest Investment Newsletter, Bill Gross, PIMCO’s high profile founder and managing director, warned that unless the US attacked its spending on entitlement programs, such as health insurance and social security “we are smelling $1 trillion deficits as far as the nose can sniff”.

Without such spending cuts, he said, the US Government would have to resort to “picking the pocket of savers”, through higher inflation, a falling currency, and low to negative real interest rates.

Gross has previously cautioned that bond yields could rise sharply – and bond prices would fall – when the US central bank’s $US600 billion bond buying program expires in June. This would cause the price of all financial assets, including shares, to drop.

Later this week, US President Barack Obama, is expected to deliver a speech outlining his plans for reducing the country’s soaring debts. The plan which is expected to include tax increases for high income earners, cuts to military spending, and savings in entitlement programs such as Medicare, the health care program for the elderly and disabled, and Medicaid, the health care program for the poor.

Last week, the Republicans outlined a plan for chopping $6 trillion off the budget deficit over the next decade, by shrinking Medicare and Medicaid and cutting social security spending. It also plans to cut the top individual and corporate tax rate to 25%, from 35% at present.

Meanwhile, John Hussman of Hussman Funds points out that many investors could be mistaken in their belief that it’s relatively “safe” to take speculative risk until mid-year because the US central bank’s $US600 billion bond buying program isn’t due to end until June 30.

Hussman tried to work out how much more the US central bank is due to spend under the program, by looking at the US central bank’s balance sheet, and by examining the permanent open market operations conducted by the Federal Reserve Bank of New York, which is responsible for buying the bonds.

Using the first approach, it appears the Fed only has about $94.8 billion of bond-buying left under its QE2 program. The second approach suggests that there’s $179 billion left in the kitty. Given that the Fed has been spending an average of $5.5 billion per business day since February, Hussman calculates that QE2 is “somewhere between 20 to 38 business days from completion”.

Hussman points out that some investors are nervous that the policy-setting Federal Open Market Committee (FOMC) could decide to terminate QE2 at its meeting later this month.

But, he says, his debate is largely irrelevant. “By the time the Fed meets later this month, QE2 will already be at least 85% complete.”

Little wonder that PIMCO and the Chinese are getting increasingly nervous.

This article first appeared on Business Spectator.