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Warning indicators on US Treasuries

PIMCO's Kashkari and Rodosky show the market is flashing warning signals on US Treasuries (source: WSJ),

We can suggest market indicators that leaders should watch for warning signs:

Increasing U.S. government debt-to-GDP ratio. From 1960 to 2007, that ratio averaged 36%. At the end of 2010, it was 62%. The Congressional Budget Office forecasts that it will climb to 100% by 2020 unless current tax and spending policies change. Research by economists Carmen Reinhart and Ken Rogoff indicates that sovereign debt begins to stifle economies' productive capacity when it passes 90% of GDP. Japan has had a ratio of greater than 150% for several years, and it has contributed to anemic growth.

Increasing inflation expectations. The U.S. has enjoyed low inflation for two decades due to the Federal Reserve's commitment to stable prices. But if that resolve were perceived to weaken, confidence in Treasurys would decline, pushing both nominal and real yields higher. Since Fed Chairman Ben Bernanke's Jackson Hole speech in August 2010, the forward five-year annual inflation rate has increased 94 basis points to 2.90%, which is now above policy makers' unofficial target of 2%.

Reduced Treasury demand from abroad. Foreign ownership of Treasurys has increased to 55% in 2008, from 34% in 2000, providing the U.S. with cheap funding. As the U.S. continues to issue record levels of Treasurys, it will grow increasingly difficult for foreign buyers, both private and sovereign, to maintain their share. For example, foreign ownership of Treasurys has fallen to about 50% today. As foreign buyers increasingly look elsewhere, U.S. funding costs could increase, creating a drag on economic growth.

Rapid dollar depreciation. A large and rapid drop in the value of the dollar would indicate concerns among investors in Treasurys and across the U.S. economy. Although currencies are volatile, the dollar index (DXY) has fallen by 5% or more in one month only 16 times since the index began 44 years ago. It has done so four times in the past two years. This suggests increased concern about the stability of the dollar.

Dramatic steepening of the yield curve. A steepening yield curve—signifying that long-term rates are climbing more quickly than short-term ones—is usually a positive indicator that reflects increased optimism for future economic growth. However, if the yield curve were to steepen while economic growth expectations remained modest, such as during a period of prolonged private deleveraging, it could indicate that investors were demanding higher rates to compensate them for increased risk over time. Today's yield curve has 10-year rates about 315 basis points above overnight rates. A spread of greater than 400 basis points would be rare and potentially concerning.


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