05/06/2012 06:14 EDT | Updated 07/06/2012 05:12 EDT

Saving Bonds

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There is no shortage of things in this crazy world that perplexes investors, and the list seems to grow daily for some. One of the simplest, yet most potentially hazardous, puzzlements out there is how interest rates in the US can remain so low (near historic lows in fact) despite a mountain of federal debt that keeps on growing.

In 1981, when the 10-year U.S. Treasury bond yield peaked around 16 per cent, the total federal debt outstanding stood at $800 billion. Last year, federal debt broke above $10 trillion and before the end of this year it will have reached $11 trillion. This seemingly mind-blowing number begs the question -- who is funding this debt and why?

The first answer is indeed simple, as the "who" behind the debt buildup is that group of nations and individuals who have surplus savings. The "why" behind this development is a little more complicated. Suffice it to say that investors are motivated by a lot of things, not just return. There's liquidity, and safety of capital to contend with as well.

Given that the U.S. dollar remains the world's reserve currency, and home to the largest and most liquid bond market, sovereign nations have long concentrated their reserves in Washington-written IOUs.

When deficits rose, and the hand went out to global savers to provide the funds needed, the call was answered, even as interest rates fell. And, as this trend of US deficit-financing intensified, the world's savers became symbiotically linked to this conundrum -- both the source of, and potential victim of the problem. As long as investors continued to buy U.S. bonds, yields would remain low, and prices of those bonds would be stable. Failure to do so would cause yields to rise, bond prices to fall, and produce capital losses for said investors. Agoraphobia is the fear of leaving a safe place; however, it is also the term applied to those afraid of being in a crowded place. The U.S. bond market has both characteristics, hence the dilemma.

For those of us with a vested interest in developments in the U.S. bond market, the vital question is what happens when someone decides to leave this safe, and crammed place first? To leave, an investor must first have an alternative place to go. That could be the equity market, and I have discussed this at length in recent weeks how an exodus from bond funds to equities could create a snap in bond yields in the US; although this would be more of a retail development, and not something the key global providers of capital would engage in. No, a viable alternative place to park reserves, or sovereign investment funds, has to be another country's bond market, and this has been the main problem -- until recently.

This week China, Japan, and South Korea signed an agreement aimed at increasing their respective investments in the countries' bonds. Though the initial purchases will be small, the plan is to raise the level of co-operative bond investments so that the currencies of the region are bolstered, with volatility in capital flows reduced. This decision also augments the soon-to- be signed Chiang Mai Initiative Multilateralization (CMIM) agreement in the region, but the increased investment in Asian bonds by Asian countries suggests that investments in non-Asian country bond markets might have to decline.

This doesn't mean the U.S. bond market is about to get clobbered.

For one, the flows into the aforementioned countries will be less than the envisioned size of the CMIM (about $240 billion), and this is less than a fifth of the size of the US budget deficit. To generate the types of outflows from the U.S. market that will keep us awake at night, something else has to happen in Asia, and that is a natural increased demand for funding. In other words, China would need to face a situation where it was forced to tap into its own reserves to finance domestic social initiatives (old age, health care, unemployment) before it would make a drastic shift away from the U.S. debt market.

The good news is that this isn't about to happen in the near future. The bad news is that it is virtually inevitable down the road. The real bad news is that around the same time that China begins to either dramatically cut back its purchases of U.S. bonds, or starts to divest itself of these bonds, other nations around the world will be arriving at the trough for financing, including Europe and Canada, to say nothing of other Asian nations.

In other words, the seeds are already planted for bond yields to climb over the long-term as we lose the traditional investors in the U.S. debt market. One way out of this dilemma is to get deficits under control and put debt (and debt/GDP ratios) on a more sustainable trajectory. If preventing a return to double-digit bond yields (and mortgage rates) in North America isn't a big enough motivation to do this, I don't know what is.