Which country prints more and runs bigger government deficits: Canada or the US?
Even though Europe is on the forefront of global bond news these days, I’d like to revisit the US Treasury market. Specifically, I’ll look at the Canadian-US bond spreads, which tell an interesting tale of Fed purchases and US deficit fears.
First, the Canadian over US government bond spreads for two longer term issues, 10yr and 30yr in chart below, have been falling for some time. Today (Jan. 10, 2011), the 10-yr Canadian Treasury over the 10-yr Treasury spread is around -12 basis points (bps), i.e., the Canadian 10-yr bond is 12 bps lower than the US 10-yr. The 30-yr spread is roughly -86 bps.
The recent divergence of the ‘spread’ between these two spreads presents a bit of a conundrum, since the two have more or less moved in lockstep.
Note: in the chart above, each dotted line represents the period average for the 30 calendar day (30-c.day) moving average spread of similar color.
The conundrum is this: the 30-yr spread has deviated well below its 2002-2011 average of 8 bps, while the 10-yr spread is sitting roughly at its average, -13 bps. But this is not a conundrum if you consider recent US policy, holding all else equal.
One the one hand, the Federal Reserve is concentrating its bond purchases in the long end of the curve, primarily below the 10-yr maturity. According to the NY Fed, 23% of the $600 bn will be allocated to the 7yr-10yr part of the curve, while just 4% will support the 17yr-30yr end. Therefore, and holding all else equal, the CAN-US spread proxies somewhat the effects of Fed policy in the bond market. The Fed is supporting the 10-yr spread roughly at trend(Section II in chart above), while contemporaneously raising inflation expectations relative to that in Canada.
On the other hand, without Fed support the 30-yr spread is pricing in not only rising inflation expectations but also an increasing US sovereign risk premium relative to that in Canada. This is a similar premium that was attached to Canadian sovereign debt in the early- to mid- 1990s (Section I in the chart above).
Compare the chart below, which illustrates the annual federal deficit in the two countries as a percentage of GDP, to the chart above. Notice how when the red line, (Canadian government deficit) moves aboe the blue line (US government deficit), the average spread drops (Section III in first chart)? That premium is now feeding into the 30-yr spread at an increasing rate (Section II of first chart).
I am in no way suggesting that the US should undergo a similar fiscal austertiy program as that taken in Canada in 1995 (please see Stephen Gordon at Worthwhile Canadian Initiative). What I am demonstrating, though – and rather qualitatively, I might add – is that absent active Fed purchases in the back end of the curve, there is a risk premium emerging in the US bond market relative to that of at least one country with markedly lower government deficits, all else equal, of course.
Note also that last month that the spread between T-bonds and BAA corporates also fell — normally a leading, concurrent indicator of stronger economic growth. Is the same thing driving smaller US quality spreads as is driving US -Canadian yield spreads? What is the historic relationship between domestic quality spreads and US- Canadian spreads?
On the other hand, without Fed support the 30-yr spread is pricing in not only rising inflation expectations but also an increasing US sovereign risk premium relative to that in Canada.
What is this “US sovereign risk premium” of which you speak — the likelihood that the US will break apart as the result of succession by its states or that the US will be conquered by a foreign power or an anti-ZOG militia which would then repudiate its debt? Do you foresee as a possibility that member commercial banks will gain complete control of the Fed and set out to wreck the US Treasury? As the US owes its debt in a fiat currency it can create without limit the only foreseeable “risk premium” associated with its debt in the coming thirty years would be that of inflation.
Markets are populated by many investors without the understanding of a printable fiat currency backed by nothing except government decree. The Fed could drive the rates downward, but they aren’t. Therefore, investors look at public debt and deficit metrics relative to alternative securities, and say hey: this looks riskier than that. Why else would markets flee to Germany in lieu of purchasing Spanish debt (given that Germany cannot print its own money)?
The probability of US default is essentially 0; it’s both willing and infinitely able (as you suggest) to honor its debts. But historically, as you see with Canada – Canada is likewise a sovreign that prints money and issues debt primarily in its own currency – markets do differentiate. The only problem here is, that the Fed’s not at the long end.
Spencer, I attached a chart with your requested illustration (email me if you want the data). As you can see credit spreads are not tightening as much as the CAN-US spreads. This is interesting, given that the outperformance of US data should affect both more or less alike.
Why else would markets flee to Germany in lieu of purchasing Spanish debt (given that Germany cannot print its own money)?
“Markets flee to Germany,” because Spain is seen as more likely to withdraw from the Euro, and thereafter repudiate some of its debt, than Germany. I suppose you’re saying that the discussion about this has led to further confusion among some investors which leads them to demand an added return for the risk of default when they buy US debt. Are investors that unsophisticated?
the 10-yr BE TIPS rate is 2.4%
the 30-yr BE TIPS rate is 2.6%
That differential does not compensate for the growing ‘spread’ between the spreads. You may be right – US CDS are up only slightly since Congress announced the tax extensions and payroll tax cut, but they’ve doubled since the outset of the crisis…
Any thoughts as to whether investors are concerned about adjustments to CPI calculations by the U.S. going forward?
Could it be balance of payment flows between Canada and the US resulting from a rebound in commodity prices?
Could it be a growing concern that the incoming Republican majority in the house, is signaling imaginary deficit reduction, shrinking government, “fixing” SSI and “targeting”the Fed be a causation?
Have you looked the the spreads between real and nominal rates?
There has been a huge drop in Canada but they were able to recover really fast and mantain a good margin more thn the US. What could have they done to have a bigger deficit?