Bond vigilantes set for rebellion against West's wasteful ways

I accept the US bond market isn’t uppermost in the mind of most Telegraph readers this weekend.

The combination of the summer sunshine, the FA Cup Final, the British Lions’ rugby tour and (whisper it) "Britain’s Got Talent" means there is plenty to distract us. Those most interested in current affairs anyway remain fixated by the MPs’ expenses scandal – so adeptly reported by my Telegraph colleagues.

I’d urge readers, though, to take a moment to consider what’s happening in the market for US government debt. The economic implications are enormous, in my view, not least for the UK.

America remains in deep trouble. The International Monetary Fund forecasts the world’s largest economy will contract 2.8pc this year – probably an under-estimate.

Unemployment is rising fast and new figures show almost 10pc of US mortgages are now in arrears – up from less than 8pc in March and the highest “delinquency count” since records began almost 40 years ago. No less than one in eight American households are now late paying their mortgage or have already endured foreclosure – such is the human impact of this ghastly sub-prime debacle.

Ordinarily, an economic slowdown of this magnitude would bolster bonds – especially the market for Western government debt, which investors traditionally view as a “safe haven”. But, despite the vicious downturn, the price of long-term US government bonds has been falling since the start of 2009, pushing up yields.

The reason, as in the UK, is that the vast scale of the American government’s indebtedness, has made investors less willing to fund US state spending by buying conventional (un-indexed) Treasury bonds.

Last week these fears came to a head – with the markets demanding a 3.75pc yield on 10-year Treasury notes, a six-month high and up from just 3.19pc the previous week. As a result, 30-year wholesale mortgage rates surged from below 4pc to 4.74pc – again, in a single week – piling the pressure on cash-strapped households, many of whom are living in fear of their jobs.

Since the summer of 2007, when the credit crunch began in earnest, the US Federal Reserve has slashed interest rates from 5.25pc to 0.25pc. The Fed has been followed, of course, by central banks in the UK and Euroland.

These cuts were designed to support our economies, taking the pressure of highly-indebted banks, firms and households. But, whatever base rates have been set by the authorities, the market is now driving borrowing costs that companies, individuals and governments actually pay much higher.

For a long time, this column has warned the bond-market vigilantes would ultimately rebel against the Western world’s profligate borrowing and spending – not least the ill-judged, cowardly and ultimate grotesque “bail-out” packages for well-connected banks that should anyway be allowed to fail.

That rebellion is now stirring in the most important economy on earth – a development that should cause us all to pause for thought, not least here in the UK, whatever good stuff is on the telly.

What happened in the US last week – almost a 60 basis-point rise in the 10-year Treasury yield, including a spike of 20 points in less than an hour - marks a significant turning of the screw. And if interest rates are driven higher still, as the market asserts its authority, this slump will be much longer, and deeper, than the vast majority of forecasters predict.

Why did US Treasury yields rise so sharply last week? One catalyst was extremely soft investor demand for a $26bn (£16bn) issuance of US government debt. Another was the latest bout of what we must call “quantitative easing” – when central banks create money to buy sovereign debt back off the markets in a bid to recapitalise the banks.

Last week, alarmingly, dealers tried to sell the Fed far more bonds than it was willing to buy. This spooked many bond traders, causing them to re-examine just how much QE the Fed can ultimately afford.

The recent decision by ratings agency Standard and Poors to warn the UK over a potential sovereign downgrade has also had implications state-side. Many think S&P could end up downgrading the US.

But these catalysts are set in the context of rising fears about inflation. Slowly but surely, global investors are becoming ever more concerned that QE, and massive sovereign debt issuance, will cause enormous Western price pressures. Core inflation remains stubbornly high and rising oil prices and the destructive impact of the credit crunch on the supply chain aren’t helping either.

Despite official warnings of deflation, the swaps market shows investors are increasingly unconvinced. Suspicions abound that governments in the US and UK, in particular, are now stoking inflation in order to monetise their massive debts.

So enjoy the sunshine while it lasts, as the bond market vigilantes will soon be making the weather.

OPEC CRANKS UP THE PRESSURE - BUT FUNDAMENTALS DRIVING OIL PRICES TOO

More pain from global commodity markets last week as oil charged through $65 a barrel. Many Western investors and politicians have been hoping “cheap crude” would see us through this crisis.

During the first quarter of this year oil averaged $42, compared to $94 during 2008. That’s helped dampen inflation by keeping the lid on energy costs to households and firms. But with crude now 103pc above its mid-February low, cheap oil is no more.

Speaking at OPEC’s Vienna summit last week, Ali Naimi, Saudi Arabia's diminutive energy minister, said recent price rises were “a function of optimism that better things are coming”.

In other words, the Desert Kingdom, the lynchpin of the exporters’ cartel controlling 40pc of all oil output, isn't raising production anytime soon. Having previously forecast oil wouldn't return to $75 until 2010, Saudi now says this could happen later this year.

Many claim the “fundamentals” point to lower oil prices as the global slowdown means less crude is needed. But, as Naimi suggests, there are now unmistakable signs demand is picking up.

The US has been at centre of the “demand destruction” story. But even in the States, crude inventories are tumbling as refineries step-up their activities ahead of the summer driving season.

US crude stocks fell 5.4m barrels last week - seven-times more than the consensus forecast. That shows just how much wishful thinking is going on among those hoping oil prices will stay low.

American petrol demand is now less than half a percent below where it was this time last year – and rising. And in the big emerging markets, of course, demand for all commodities continues to grow at breakneck speed.

CHINA LEADS THE WAY

Talking of which, rising demand for raw materials in China caused the Baltic Dry Index to jump last week. The benchmark for the cost of transporting bulk commodities such as coal, iron ore and grain, the Baltic Dry surged no less than 25pc to almost 3,500 – a seven-month high.

While China is by no means immune to the global slowdown, it is faring better than any other major economy. As such, the People's Republic is far more likely than the “advanced” Western economies to lead the world out of its current slump.

New official estimates suggest China will grow 7pc during the second quarter of 2009, up from 6.1pc between January and March. The latest Chinese PMI indices are above 50, indicating companies are expanding their output.

Across China, property prices are rebounding and car sales are soaring. Last month, GM reported a 50pc annual increase in sales, while Ford’s numbers were 33pc up. China has just overtaken the US to become the world’s biggest car market.

These commercial realities, of course, imply a shift in raw political power. No wonder Tim Geithner, US Treasury Secretary, is going to Beijing this week – to give reassurances America is committed to long-term fiscal discipline and plead with China to keep buying US government bonds.
 

Liam Halligan is Chief Economist at Prosperity Capital Management