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Analysis/Comment Last Updated: Nov 28, 2011 - 4:08 AM


Dr Peter Morici: Investors should be wary of buying US Treasuries
By Professor Peter Morici
Nov 28, 2011 - 3:55 AM

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President Barack Obama and daughters Sasha and Malia shop at Kramerbook & Afterwords Cafe in Washington, DC, Saturday, Nov 26, 2011.

Dr Peter Morici: The Super Committee’s failure to compromise on $1.2trn in budget savings won’t much affect the deficit and US credit ratings—or the interest rates and prices of US Treasuries.  Still investors should limit holdings of those securities—the long term outlook is not good.

Although the Super Committee did not reach consensus on a combination of spending cuts and tax hikes, the Budget Control Act automatically triggers $1.2trn reductions in defense outlays, nonentitlement domestic spending and some payments to hospitals and health care providers.

Savings from winding down wars in Afghanistan and Iraq were already scored into budget projections; hence, new defense cuts will be from the “base” military budget that maintains readiness and defends US security interests around the globe.

The Budget Control Act, passed in August, already cut defense spending by $450bn over ten years, and another $500bn is simply unacceptable. US hardware is aging—sons fly the same fighters as did their fathers; cyber warfare requires new capabilities beyond conventional land, air and sea forces; and China is building a navy and will spend on defense 60% as much as the United States within a decade—with lower personnel costs and without America’s global responsibilities. More, not fewer, naval resources are needed to meet that challenge in the Pacific—on a recent trip to Asia, President Obama committed to a beefed up US presence.

Republicans in Congress will propose repealing the $500bn cut but liberal Democrats will demand that spending be refinanced with other cuts or new taxes. Grover Norquist won’t be able to stop such a deal—hard realities, especially national security concerns, have a way of neutralizing the clout of mono-line political activists.

A deal on defense spending will legitimize similar tradeoffs to reduce other Budget Act mandated cuts and make some tax increases acceptable, even among many conservative Republicans.

Consequently, the impact on the deficit of the Super Committee failure will be marginal. The budget dance that follows should not provide a basis for S&P to lower its AA+ bond rating on US bonds, or for Moody and Fitch to lower their AAA ratings.

Longer term, the cuts the Budget Act required won’t be enough. The United States will continue to borrow too much and grow too slowly until more important structural issues are addressed. Within a few years, US borrowing costs will be much higher than today.

Currently, Washington enjoys low borrowing costs, because foreign central banks, private institutions and ordinary investors are all fleeing European debt. Similarly, China’s shaky banks and dodgy accounting standards, along with Beijing’s exhortations that yuan appreciation has run to course, are causing money to flee China for America. That money is dumping into Treasuries, solid corporate and state debt, and even junk bonds.

Within a few years, that money will leave, after Europe has its ultimate financial crisis and then recovers and investors realize that China’s sovereign debt is no more risky than US paper. Rates on Treasuries will rise, as investors become much more nervous that either Washington won’t be able to continue floating $1trn a year in new debt or the Fed will simply roll the printing presses to buy what Treasuries investors won’t take.

Long bond rates will rise, and Treasuries bought today will lose value. Simply, in 2014, why would someone pay as much for Treasuries maturing 27 years later and yielding 3%, when a new 30 year bond pays 5%. At that point investors who purchased bonds today either must wait for those to mature and endure low interest rates, or take a haircut if they sell.

The message to the ordinary investor is simple, Treasuries are safe up to a point—the US government can always print money if necessary to honor its debt—but those investors should only buy bonds with maturities no longer than their circumstances permit them to have their money tied up. Treasuries won’t long be a liquid investment.

Peter Morici,

Professor, Robert H. Smith School of Business, University of Maryland,

College Park, MD 20742-1815,

703 549 4338 Phone

703 618 4338 Cell Phone

pmorici@rhsmith.umd.edu

http://www.smith.umd.edu/lbpp/faculty/morici.html

http://www.smith.umd.edu/faculty/pmorici/cv_pmorici.htm

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