Will the US Default on Their Debt Obligations?

When you’re this far down the monetary rabbit hole, it would be pretty brave to discount any eventuality. So today we’re going to question whether the US government can, or will, really default on their debt obligations. In preview, our answer is, ‘No they won’t.’ When you issue debt denominated in the currency you print – and which the world accepts – default is practically impossible. But that doesn’t account for the madness of politicians…

That’s because politicians can easily bring about a ‘technical’ default. That is, because the US government doesn’t have the legal authority to borrow more money right now (authority it needs from Congress) and because it’s fast running out of cash, the US Empire’s immense bills could well go unpaid.

So if Congress can’t agree to an increase in the debt limit by October 17, then they will trigger a technical default. And the world will collapse in a smoking pile of ruins…

Well, maybe not quite. But there are obviously some concerns about the continuing impasse and the belligerence of both sides of politics over the issue. Obama says he won’t negotiate until Congress approves an increase in the debt ceiling and the Republicans won’t approve an increase until Obama comes to the negotiating table.

The result? A lot of nervousness. The Financial Times headlines with ‘China and Japan warn on US default‘. According to Treasury data, they are the number one and two holders of Treasury debt, at US$1.277 and US$1.135 trillion respectively.

Bloomberg goes the full hyperbole with:

Failure by the world’s largest borrower to pay its debt — unprecedented in modern history — will devastate stock markets from Brazil to Zurich, halt a $5 trillion lending mechanism for investors who rely on Treasuries, blow up borrowing costs for billions of people and companies, ravage the dollar and throw the U.S. and world economies into a recession that probably would become a depression. Among the dozens of money managers, economists, bankers, traders and former government officials interviewed for this story, few view a US default as anything but a financial apocalypse.

We wonder who will blink first?

Bloomberg does have a point. The world’s financial system relies on the constant expansion of US debt. If it stops, the global economy will grind to a halt. But more crucially, a technical default would wreak havoc in the financial markets.

That’s because it would call into question the value of the world’s most used collateral – the US Treasury bond. What do we mean by that?

Well, because Treasuries are seen as ‘risk-free’ (really) they are accepted globally as collateral. So if you want to borrow cash you can hand over a Treasury bond as collateral and then go and invest that cash elsewhere. And then the person or entity who holds the bond as collateral can go and hand it to someone else in exchange for cash too. It’s known as re-hypothecation and is a way of turning one Treasury bond into multiples of its cash value. It’s a process that helps to levitate financial markets.

We’d guess that in the event of a technical default, there would be a fair amount of confusion (not to mention anger) about what this means for the ‘Treasuries as collateral’ trade.

Which is why we think a default won’t happen. Between now and next week, bankers will constantly remind the politicians what a dangerous game they are playing. Bloomberg reports that Morgan Stanley boss James Gorman urged employees to write to their Congressman and warn them of the ‘unacceptable consequences‘ of default.

And if letters or emails don’t work, a bullet in the mail will probably focus the senses…

While the stakes appear quite high in the political world, in the financial world no one seems to think a default is likely. US 10-year Treasury bond yields are 2.63%, compared to 2.94% a month ago. That means Treasuries are in demand. As yields go down prices go up, so buyers are clearly not concerned about a default. If they were, you’d see yields rising strongly.

So the bond market is telling you there won’t be a default. Yet the equity market is falling. What’s the story?

Well, with the Federal Reserve monetising US$85 billion of debt paper per month, the equity market has become somewhat of a casino. As cash flows into the financial system, it’s like a hot potato that no one really wants to hold. More pertinently, no one wants to hold it while the going is good and confidence remains high.

But when there is a blow to confidence, the potato cools down. Cash doesn’t seem so bad and there is a tendency to hold onto it for longer than before. So the equity market is largely a factor of confidence, and when you have politicians threatening to turn off the monetary taps, confidence takes a hit.

That’s an important point to note. We often talk about the Federal Reserve being the source of the world’s liquidity but really, the source starts with government. It’s the government’s ability to borrow (by issuing Treasury paper) and spend which puts the cash into the system.

The Federal Reserve’s role is to simply monetise these Treasury obligations (money already spent) in order to keep interest rates low and allow the Treasury to continue issuing more and more paper.

This is why the shutdown and the threat of no more debt issuance is such a worry to the equity market. The global liquidity/money/cash tap is at risk of being turned off and however unlikely it is right now, equities don’t like it.

If we’re right the US will avoid default and you’ll see some sort of agreement between the two political parties in the next week or two. It will be interesting to see the market’s response. You’ll initially see a knee-jerk rally in equities and perhaps even a sell-off in the Treasury market. But what happens after that will be important.

Will any rally be sustainable? Or will the current political wrangling awake the rest of the world to the enormity of the US’s debt problems? Will foreigners continue to desert the Treasury market (as we pointed out yesterday) meaning the Federal Reserve will have no chance of ending QE?

If that is indeed the case, it’s hard to see how confidence, and bond prices, will hold up. Dwindling confidence and rising bonds yields won’t be good for the stock market.

It won’t be good for the global economy or the Australian economy either. In fact, my mate Dan Denning reckons Australia is on the path to its first recession in decades, with or without the US debt issues.

The major underlying theme of the Daily Reckoning has been to document the decline of the American Empire. We do it – with good humour – not because that’s what we’d like to see, but because it’s an inevitable consequence of history and economics. It is what it is.

But we think that 2013 will go down as the year when the pace of decline accelerated. The hopeful recovery from the 2008 bust – built entirely on US government debt growth – is running out of steam. Harsh reality and the limits of debt-based growth are not far away.


Greg Canavan+
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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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