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Stomachs of steel for U.S. debt

July 30, 2009

Bond market vigilantes — investors who punish profligate governments by pushing up their cost of borrowing — have been remarkably quiescent.

This week the U.S. government has broken all records for debt sales. Come Friday investors will have bought $115 billion of freshly minted Treasury paper, and given the huge scale of these auctions, investors have shown only modest signs of indigestion.

The Treasury might have had to pay more than it would have liked, but the yield on 10-year U.S. government bonds has risen only infinitesimally. So far there are few signs the surge in government borrowing is “crowding out” businesses coming to the market for cash.

Indeed the reason behind the willingness of investors to swallow huge amounts of Treasury debt at extremely low rates is not immediately apparent. It is also a little disappointing for political hacks anticipating the Schadenfreude of seeing the Obama administration being castigated by the markets.

A yearning for safety by anxious traders does not appear to be the answer. Despite a modest stock market retreat in recent days, there appears to be no shortage of risk takers in the market. Precautionary holdings of cash are at their lowest level since May 2007, according to a Reuters poll.

But there are plenty of other reasons why the bond vigilantes might feel on the back foot. While levels of government borrowing are alarming, the outlook for price stability is not. With wage increases almost vanishing, inflation still seems a distant threat.

More important still, the Federal Reserve has stacked the cards in favor of their friends at the Treasury.

“The amount of cheap money being made available by the Fed has simply been overwhelming the supply,” according to Charles Comiskey, head of U.S. Treasury trading at HSBC Securities. “This new money has to go somewhere.”

More directly, the Fed has also been buying chunks of Treasury issues as part of its credit easing strategy — making it easier for the market to digest the remainder.

Foreign central banks have largely sat out this week’s auctions, according to traders. Even so, the central banks have been lending a helping hand in recent months.

In the three months to June they scooped up more than $170 billion of Treasuries, according to Fed figures on the assets they hold on behalf of overseas peers. The pace of these purchases is likely to accelerate as foreign central banks seek to rebuild their depleted holdings.

Yet bond vigilantes may get the last laugh.

At present the Treasury enjoys a relatively clear field. With demand still weak, companies are in no mood to invest. Where they have borrowed, it has mostly been to roll over existing debt — an easier sell for investors. All being well this will not last.

When private demand for capital picks up and the artificial prop provided by the Fed’s credit easing is removed, the government will face the judgment of the market. Congress and the White House would be well advised to start setting the fiscal house in order before this happens.

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