Global Bond Markets Change Rules of the Game

David Wyss, chief economist with Standard & Poor's, last month delivered a speech in New York during which he outlined his forecast for the U.S. economy in the near term. One quote in particular struck me. “I don't know what's going to happen next, but there is a lot that can go wrong,” Wyss told several hundred hotel execs who gathered at the Waldorf-Astoria for New York University's annual hospitality conference.

To be clear, Wyss is not a pessimist. He predicts that U.S. economic growth will reach 3.5% this year, which is less than last year's 4.4% but still healthy. And he projects inflation will be held in check at 2.25%. Such stability, coupled with the current unemployment rate of 5.1%, form the basis of his optimism. “I'll take 10 years like that right now,” Wyss insists. “In the 1970s and 1980s, I knew of politicians who would have traded their grandmothers for that [prosperity].”

So, if the economic engine is running so smoothly at midyear, why does our cover story reach the conclusion that the glass is only half full? And if you're a borrower, what do investment trends in China, Japan or Europe have to do with your cost of capital?

Let's start with the first question about the glass being half full, or half empty, depending on your point of view. The low 10-year Treasury yield — 3.9% as of June 27 — has primed the pump for a record volume of commercial and multifamily loan originations, which inevitably will lead to overbuilding in some markets and property sectors. It's really not a question of if, but when, overbuilding will occur, all of which challenges the theory that the capital markets are too efficient today to repeat the sins of the past.

Up until now, the focus of our coverage regarding low interest rates has been on how the cheap debt is driving up sale prices and compressing cap rates. That's only part of the problem. If lenders fail to exercise restraint, and there are mounting signs that is the case, developers will do what they do best, which is to overbuild. The competitive pressures among lenders to get money out the door only contributes to the problem.

As for the answer to the second question, what occurs in the bond markets in China or Europe does indeed have a direct impact on U.S. borrowers. “The bond markets and the financial markets have become global,” emphasizes Wyss. “Even though a 4% interest rate on a 10-year bond doesn't sound like a high interest rate to us, if you're a German investor and you get only 3.25% on your German bonds, 4% looks pretty good.” To Japanese investors who only get about 1% yield on long-term Japanese bonds, a 4% yield in U.S. Treasuries looks even more attractive.

So, it's little wonder that Japanese holdings of U.S. Treasuries doubled in 2004 to $702 billion, or that China purchased nearly $50 billion in U.S. Treasuries last year to bring its holdings to a whopping $196 billion. All this buying of U.S. Treasuries by foreign investors is driving down the yield of the long-term bond. The real question is this: What happens when these countries tire of gobbling up U.S. Treasuries? No one is certain. Wyss and many other economists don't see that situation coming to pass anytime soon. In a global economy, everything is relative when it comes to yield. And right now, the U.S. is still the best bet.

Still, borrowers need to recognize that a 4% yield on the 10-year Treasury is not a permanent condition, even if it really feels that way at the moment.

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