Rising U.S. bond yields may spark Credit Crisis II

By John Parry - Analysis

NEW YORK (Reuters) - The global financial crisis may morph into a second, equally virulent phase where borrowing costs rise again, hobbling an embryonic economic recovery, debilitating cash-strapped banks, and punishing investors all over again.

Early warnings signs of this scenario include surging government bond yields, a slumping U.S. dollar, and the fading of the bear market rally in U.S. stocks.

Optimists hope that a fragile two-month rally in world stock markets, a rise in U.S. Treasury yields from record lows during the depths of the crisis in late 2008, and some less scary economic data all signal that a recovery is around the corner.

But gloomy analysts insist that thinking is delusional.

Once Credit Crisis Version 2.0 ramps up, foreign investors may punish the U.S. government for borrowing trillions of dollars too much by refusing to buy its debt until bond prices plunge to much cheaper levels.

The telling harbinger is benchmark Treasury note yields' surge to six-month highs around 3.75 percent this week, as investors began to balk at the record U.S. government borrowing requirement this year.

The U.S. Treasury plans to sell about $2 trillion in new debt this year to fund a $1.8 trillion fiscal deficit.

Heavy selling of U.S. dollar-denominated assets could trigger a full-blown currency crisis and usher in surging inflation, forcing mortgage rates and corporate bond yields up, undermining any rebound in economic activity.

"The financial crisis is a downward spiral with two twists," said George Feiger, chief executive of Contango Capital Advisors in Berkeley, California.

First came the banking crisis and a huge contraction of credit, starting in mid-2007 which resulted in the stock market panic of 2008 which triggered the deepest U.S. recession in at least two decades.

"Once you have got a recession you have good old-fashioned credit losses," Feiger said. "The second leg is now the consequences of the massive recession and it is just now working its way out," he said.

Investors, many of them foreigners who own a large chunk of the U.S. Treasury market, are steadily demanding higher yields.

The price of the historic rescues of banks, insurers, manufacturers, and securities markets, to prevent a complete collapse during the worst financial crisis since the Great Depression, has meant a record U.S. government borrowing requirement.

But by issuing so much debt, the United States risks repulsing a critical buyer: foreign central banks, who own more than a quarter of marketable U.S. Treasuries. China recently overtook Japan as the biggest such buyer.

"We are getting into that stage which I call 'the markets revenge'", said Martin Weiss, president of Weiss Research Inc. in Jupiter, Florida.