May 21, 2009 / 11:27 PM / 8 years ago

Unraveling markets bode ill for U.S. economic might

NEW YORK (Reuters) - The long shadow of a multi-trillion dollar financial rescue program is beginning to shake investor confidence in U.S. economic supremacy.

In a nervous day in financial markets, dollar-based assets took a rare, simultaneous plunge.

Coming on the same day as a warning from credit agency Standard & Poor's on Britain's AAA rating, the drop in U.S. stocks and Treasury bonds, along with the greenback itself, rekindled concerns about the U.S. Treasury's ability to finance a $1.75 trillion deficit.

"Normally you don't see this confluence," said Howard Simons, market strategist at Bianco Research.

Fearful markets usually translate into gains for Treasury bonds and the dollar and losses for riskier stocks. The tandem, across-the-board declines on Thursday reflected anxiety over the U.S. government's mounting indebtedness as it grapples with the worst financial crisis in generations.

The amounts in question are staggering. The government has said it will need to borrow $2 trillion, or 14 percent of the country's total economic output, in 2009 alone. The Treasury will raise $101 billion just next week.

It has already sunk most of its $700 billion Treasury Asset Relief Plan, or TARP, into propping up struggling banks and other financial institutions. It also juiced up the economy with a $787 billion fiscal stimulus plan.

Moreover, the Federal Reserve has committed to buying nearly $1.5 trillion in mortgage and agency debt issued by Fannie Mae and Freddie Mac, the fallen government-supported mortgage behemoths, along with $300 billion in direct purchases of U.S. government bonds. Minutes from the central bank's April meeting, published on Wednesday, suggested policy-makers were pondering a possible expansion of such programs.

"No one wants to admit it, but there might be investors nervous enough with the extreme levels of indebtedness of the U.S. government so that just the thought of a downgrade would provide an excuse to sell dollars," said Matt Esteve, a currency trader at Tempus Consulting.

On Thursday, investors decided it was time to get out, pushing the S&P 500 index, which rallied more than 35 percent over the last two months, 1.7 percent lower on the day. At the same time, the 30-year Treasury bond fell three full points in price and its yield jumped 0.17 percentage point to 4.33 percent, the biggest one-day increase in two weeks.

The dollar index, which captures the greenback in relation to a basket of major currencies, is down 7.5 percent in just the last month. The cost of hedging against a U.S. government default, which fell rapidly in recent weeks, crept back up.

At the back of investors' minds is the fear, long latent but now more prevalent, that foreign buyers of U.S. bonds, especially China, might tire of lending America money.

TRIAL BY PROXY

One reason for connecting the threat of a credit-rating downgrade in Britain with the U.S. economic outlook is that the two countries, despite their disparate sizes, have worrying similarities.

Both are mired in financial crises that were fed and reinforced by bubbles in housing. Both became hostage to a bloated financial sector that proved to be much more fragile than many regulators previously believed.

More importantly, both nations have tackled the crisis in a similar way: by pumping massive amounts of capital into the banking system in an effort to reflate falling asset prices.

Britain's fiscal profligacy has already led to a failed auction of gilts, defined as one in which there are not enough bidders for the amount of bonds on auction.

The United States has not yet experienced such a misfortune, particularly with the Fed propping up the market. But the prospect now appears less far-fetched than before.

"Don't think for a second that the same cannot happen to the USA at some point, judging by the massive run-up in government debt and debt guarantees," said David Rosenberg, chief economist at Gluskin Sheff in Toronto, Ontario.

Bill Gross, co-chief investment officer of bond fund PIMCO, which oversees more than $800 billion in assets, said investors fear the United States is "going the way of the U.K. -- losing the AAA rating which affects all financial assets and the dollar."

Dollar bulls say such talk is overdone. Given the lack of alternatives to the greenback and the U.S. currency's dominant status as the world's reserve, any wave of selling is eventually likely to attract new buyers.

Still, traders looking at all the red flashing across their screens were seeing it differently for now.

"We're coming back to the circular argument that if you wake up drunk in the gutter the best thing to do is to have another half pint of Jack Daniels," said Simons. "At some point, solving a bubble by creating another bubble is not the way to go."

(Additional reporting by Jennifer Ablan and Richard Leong)

Reporting by Pedro Nicolaci da Costa; Editing by Dan Grebler

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