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GAAP: Crazy But True

Generally accepted accounting principles say US Treasury bonds are doomed...

"ALL THINGS must pass," George Harrison mournfully crooned on his 1971 album of the same name, writes Eric Fry in the Rude Awakening.

"All things must pass away...Sunrise doesn't last all morning. A cloudburst doesn't last all day..."

And neither, of course, does a superpower's global economic hegemony.

America's dominance of the global economy is falling victim to self- inflicted wounds – namely, extreme and rising indebtedness. America's recent flood of red ink would make a banana republic blush.

As a result, risk-free Treasury bond may not be as "risk free" as they used to be. A few days ago, the highly regarded hedge fund manager, Julian Robertson, revealed that he is purchasing long-term put options on long-term Treasury bonds. In other words, he thinks their long-term value is lower from here. And his reasoning is persuasive.

"If the Chinese and the Japanese stop buying our bonds," Robertson explained during a CNBC interview, "we could easily see [interest rates] of 15% to 20%...

"It's a question of who will lend us the money if they don't. Imagine us getting ourselves into a situation where we're totally dependant on those two countries. It's crazy."

Crazy, yes, but true.

The US financial markets, especially the credit markets, benefit greatly from both familiarity and reputation, more than merit; past reputation, more than future reliability. But "reputation" doesn't pay the bills.

The growth of emerging economies is "symbolic of the relative, less dominant position the United States has, not just in the economy but in leadership, intellectual and otherwise," former Federal Reserve Chairman Paul Volcker said in an interview with Charlie Rose last week.

"I don't know how we accommodate ourselves to it," Volcker continued. "You cannot be dependent upon these countries for three to four trillion Dollars of your debt and think that they're going to be passive observers of whatever you do."

The US government, like one giant General Motors, is technically insolvent. And yet, it borrows at low 'triple-A' rates of interest because of its long-term legacy of world-beating economic success. That triple-A credit rating does NOT come thanks to America's recent history of extreme indebtedness.

The fiscal condition of the United Sates has deteriorated dramatically during the last several years. On the basis of current obligations, US indebtedness totals "only" about $12 trillion. But when utilizing traditional "generally accepted accounting principles" (known as GAAP) – the kind of accounting that every public company in the United States MUST use – US indebtedness soars to $74 trillion.

This astounding sum – including things like the present value of the Social Security liability and the Medicare liability (i.e. real liabilities) – is more than six times US economic output...

Perhaps this mind-blowingly large debt load would seem less mind-blowing if it were decreasing. But it is not. Instead, the current US administration is amplifying the long-standing American habit of spending money it does not have.

The chart below tracks the federal budgets for both America and Brazil as a percentage of each country's gross domestic product. Back in 1998, the US ran a budget surplus, while Brazil was running a deficit equal to 9% of GDP. But the two nations have since traded places. At last count, the US budget deficit totaled an astounding 9% of GDP, while Brazil's deficit totaled only 3.3%...

And yet, the US government pays only 3.28% in interest per annum to borrow money for 10 years. The Brazilian government must pay 5.05% to attract investors to its 10-year bonds.

Thus, the yield spread between these two borrowers is 1.77 percentage points – or 177 "basis points" – and gives the advantage to the United States, despite its massively greater debt burden.

At this point, a brief tutorial may be in order...

Like a polite dinner guest, the bond market does not express its opinions in absolute terms. Rather, it renders a relative judgment.

It prices specific bonds relative to other bonds, or specific credit instruments relative to others. This relative pricing is known as the "yield spread" – and the most common yield spread comparison is made relative to US Treasury bond yields. So for example, if a certain 10-year bond issued by a corporation or a foreign nation is yielding 6.50% at the same time that the US 10-year note is yielding 4.50%, that bond is said to be trading 200 basis points over Treasurys. In other words, it's paying 2.00% more than the US debt.

The higher the spread over Treasurys, the riskier the debt is perceived to be. Because the United States Treasury is deemed to represent the ultimate "risk free" debtor. And this is where our story takes an interesting turn...

The yields on foreign sovereign bonds (i.e. government bonds) have been falling closer to US yields for several years. This process has been unfolding gradually, and in fits and starts. But over time, the trend is clear. What's not clear is who is moving closer to whom.

Are foreign sovereign issuers becoming MORE credit-worthy or is the US government becoming LESS credit-worthy? Or is it a little bit of both?

Whatever the case, the nearby chart illustrates the result. Using a four-year rolling average of yields (to smooth out the trend), it is easy to see that Developed World interests rates are converging toward US rates. Canadian and French sovereign 10-year interest rates, for example, have been moving closer to US rates for several years. (And in fact, French rates have dipped below US rates several times during the last several years).

This narrowing of yield spreads is not only evident among issuers like Canada and France, but also among emerging market issuers – especially the rapidly emerging market issuers like Brazil.

Some investors might infer, therefore, that emerging market bonds are now too expensive relative to US Treasuries. (Higher prices push the yield offered down, since the actual cash income paid is fixed.). But we would take the other side of that trade:

Risk-free US Treasury bonds are not as risk-free as they used to be.

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Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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