Confidence in U.S. bonds slipped well before threat of downgrade

The threat of the first downgrade of U.S. government debt - for decades considered the safest investment in the world - came as a jolt to some in Washington last week, but financial markets foreshadowed the move for months.

Many global investors already essentially downgraded the U.S. by voting with their feet and increasingly shunning U.S. bonds.

Among the strongest signs that the U.S. was losing its luster among the world’s investors has been the steady decline of the U.S. dollar against most other currencies as foreign investors, worried about burgeoning U.S. budget deficits, sought ways to avoid putting their cash in dollars and U.S. government obligations.

China and other major emerging countries that have invested most of their trillions of dollars in cash reserves in U.S. Treasurys for months have been seeking to diversify out of U.S. holdings on the expectation that the dollar will continue to fall while budget deficits continue to swell into uncharted territory of more than $1 trillion a year.

China, Treasury’s largest foreign investor, has made no secret of its unhappiness with the precarious fiscal situation and heeded the advice of a little-known Chinese rating agency that downgraded the U.S. from AAA to A a year ago.

The price of gold - considered the ultimate safe haven for investors who worry about the deterioration of U.S. finances - has soared in the past year and reached record highs of more than $1,500 an ounce last week after Standard & Poor’s Corp. became the first Wall Street agency to warn that the U.S. might lose its top AAA credit rating.

Perhaps the markets raised the biggest red flag this year when the world’s largest bond fund, Pimco, announced that it was dumping its Treasury holdings out of concern that the U.S. Congress and Obama administration are nowhere close to facing the facts about the need to rein in federal benefits programs and raise taxes.

“Unless entitlements are substantially reformed, the U.S. will likely default on its debt” in a subtle and disguised way, said Pimco chief William H. Gross.

Mr. Gross said he doesn’t expect the U.S. to default outright on its obligations and stop making payments on the debt. Rather, he warned of a kind of “backdoor” default process already under way, whereby the U.S. Federal Reserve and Treasury spur inflation through devaluation of the dollar to enable the government to “inflate” its way out of the debt. At the same time, the Fed is holding interest rates at artificially low levels that do not compensate bondholders for the increase in inflation.

While many in Washington have feared that China or Japan might one day stop buying U.S. Treasury bonds, China has diversified into other countries’ bonds gradually to avoid impairing the value of China’s massive U.S. holdings.

It was the sudden exit of Pimco - one of the major investment funds in the U.S. - that should have set off alarm bells in Congress, analysts say.

“Pimco out of Treasurys? That’s like McDonald’s deciding not to buy any more hamburger meat,” said economic commentator Gonzalo Lira.

S&P’s warning about a downgrade April 18 only “highlighted a fact that everybody already knows,” he said. “Treasurys are nowhere near as gilded as people would like to believe.”

“We shouldn’t be surprised at the concerns” raised by S&P, said Carmen Reinhart, senior fellow at the Peterson Institute, noting that investors worldwide have been signaling concern about the deteriorating U.S. fiscal situation for a long while.

With deficits ranging around $1.5 trillion recently and projected to stay nearly that high for years to come, the fast-growing U.S. debt burden is at the “extreme end of the spectrum” among advanced countries, she said.

Ms. Reinhart is co-author of a much-discussed study showing that countries whose gross debt exceeds 100 percent of their yearly economic output experience more sluggish economic growth. She said the U.S. is approaching that level and has already exceeded that level if the debts of state and local governments and government-sponsored enterprises by Fannie Mae are added.

“Markets haven’t reacted wildly to the S&P news,” because most investors were already well aware of the dangers associated with the growing U.S. debt load and the implications for the global financial system, she said.

Ms. Reinhart said Washington’s usual excuses for not tackling the debt problem are getting “old.” Politicians argue that the economy is still fragile and another election is just around the corner, so nothing serious can get done while everyone is campaigning. Each party blames the other for years of inaction.

“Can anyone tell me if there is a good time to make difficult decisions about spending and taxes?” asked Ms. Reinhart. “I really don’t think there is a good time politically.”

John Spinello, chief strategist at Jefferies & Co., said S&P’s announcement was a “shock” that shook the U.S. bond market for about an hour April 18. But then traders went back to worrying about the more immediate debt problems in European countries such as Portugal and Ireland.

“No one in the financial universe” had expected S&P to emerge as a “deficit cop for the government” last week, he said. But in the end, the credit agency’s message to the government to “get your house in order” was no surprise to markets that have had to absorb billions of dollars of new Treasury-debt issues each week.

In the gold market, “fear about the nation’s debt and deficit” has helped cause a more than tripling of prices from $437 an ounce in 2005, and gold is likely to go still higher in coming months, said Scott Anderson, senior economist at Wells Fargo Securities.

“The big issue is the fate of the U.S. dollar in the face of soaring government debt and deficits,” he said. Reversing the decline won’t be easy, he added.

“Finding a solution to the nation’s budget woes will be a tremendous challenge and will entail significant sacrifices that many Americans may be loath to endure.”