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The US debt drama – soap opera or Lehman quality?

2013/10/30

Shortly after the US default had been averted on October 16, the S&P 500 closed at an all-time peak of 1,744.50. Alan Wheatley (Reuters) commented enthusiastically:

“If Wall Street’s record high is a signpost, the U.S. economy has every chance of pulling further ahead of a stuttering Europe despite new battles to come in Washington over the government’s budget and debt ceiling.”

Does this mean that all the worries of the past weeks about a “Lehman moment” were nothing but hot air? Is the debacle that we observed nothing more than an episode in an endless soap opera that long ceased to impress markets?

A glance at the recent history of debt-ceiling increases in the US seems to support this view.

ShutdownE_Table U.S. Debt-Ceiling Increases

Randy Yeip (Wall Street Journal) explained:

“Over the past six presidential administrations the debt ceiling has been raised 45 times, usually only when debt levels are dangerously close to the limit. In fact, 37 of those increases occurred when debt reached 98% or more of the debt ceiling. Over that period the debt limit has had to be raised, on average, every nine months. And when Congress and the president have been unable to reach an agreement to raise the limit, the Treasury Department has resorted to various “extraordinary measures” to meet its obligations.”

Nevertheless, the fears are real. The following quotes illustrate how, in many respects, the current episode differed from former ones.

The risks

Which were the risks? I would like to quote three views:

Michalis Nikiforos of the Levy Economics Institute, Bard College wrote in September 2013:

“If Congress does not agree to raise the debt ceiling, the consequences are even more uncertain and perplexing than those of the ongoing shutdown, because there is no precedent for a US government default, and there is a series of legal and technical questions that are very difficult to answer.

Examination of these consequences usually starts with the effects on the creditworthiness of Treasury bonds and the repercussions for financial markets and the real economy. If the debt ceiling is not raised, the US government will default, the rating of Treasury bonds will be downgraded to “selective default” status, and payouts on US sovereign CDSs will be triggered. This could act as a new “Lehman moment,” pushing the US and global economies back into recession.”

The Banker’s Umbrella warned:

“If we get to the point where the US is late on an interest payment on its debt (let me stress I don’t think we will) then we are in unchartered waters. The risk is this: US treasuries are held all over the world as collateral for loans. In any default situation the collateral of the underlying is adjusted. What happens when the collateral value of US treasuries is adjusted downwards? Margin calls the likes of which we have never seen. The market will go haywire as treasuries have to be dumped to raise collateral (interest rates spike) or then equities that have been bought with margin that has treasuries as collateral are dumped (stocks plummet). It’s just a very scary scenario and a thing that everyone should fear like the plague.

If we did go test those waters, then things could very quickly spiral out of control. What we saw with Lehman Brothers would be minor in comparison.”

Felix Salmon saw the damage done already and drew attention to the possible wider consequences:

“The global faith in US institutions has already been undermined. The mechanism by which catastrophe would arise has already been set into motion. And as a result, economic growth in both the US and the rest of the world will be lower than it should be. Unemployment will be higher. Social unrest will be more destructive. These things aren’t as bad now as they would be if we actually got to a point of payment default. But even a payment default wouldn’t cause mass overnight failures: the catastrophe would be slower and nastier than that, less visible, less spectacular. We’re not talking the final scene of Fight Club, we’re talking more about another global credit crisis — where “credit” means “trust”, and “trust” means “trust in the US government as the one institution which cannot fail”.”

And he added: “If Treasury payments can’t be trusted entirely, then not only do all risk instruments need to be repriced, but so does the most basic counterparty risk of all. The US government, in one form or another, is a counterparty to every single financial player in the world. Its payments have to be certain, or else the whole house of cards risks collapsing — starting with the multi-trillion-dollar interest-rate derivatives market, and moving rapidly from there.”

Policy reactions

More than on other occasions before, governments worldwide seemed aware of these risks as statements made by both policy makers and central banks show. In the US, officials at the White House and the Treasury confirmed that contingency plans were in place. Staff members at the Treasury, Federal Reserve and Federal Reserve Bank of New York were reported to be working together behind the scenes to prepare for the worst.

In the UK, Jon Cunliffe, the newly appointed Deputy Governor for Financial Stability of the Bank of England, told members of Parliament that in Britain banks should be developing contingency plans to deal with an American default if one happens, as Michael D. Shear and Jeremy W. Peters (The New York Times)  wrote on October 15, two days before the deadline ended.

They also reported that in a commentary the state-run Chinese news agency Xinhua called on a “befuddled world to start considering building a de-Americanized world” and that the “international community is highly agonized.”

According to Niklas Magnusson and Evgenia Pismennaya (Bloomberg) on October 16, Russia joined China in warning that countries may intensify their search for alternative reserve currencies.

From the same authors we learned that Sweden and Denmark were bracing themselves for a US default. Swedish Finance Minister Anders Borg was quoted emphasizing that his country would ensure its financial system has access to US currency in the event markets would be disrupted, adding:

“We’ve never been in an equivalent situation before and it’s therefore very difficult to judge what impact it will have … It’s essentially about fear and psychological factors.”

Swedish Prime Minister Fredrik Reinfeldt confirmed: “we’re taking this very seriously” .

European Union Economic and Monetary Affairs Commissioner Olli Rehn expressed his concern in a Bloomberg TV interview, and referring to earlier US warnings to Europe to resolve its debt crisis he remarked: “There’s no schadenfreude.”

European Central Bank President Mario Draghi said in Washington on October 12:

“It’s quite obvious that if this situation were to last a long time, this would be negative, very negative for the U.S. economy and the world economy”.

On the other hand, Simon Kennedy, Jeff Black and Jennifer Ryan (Bloomberg) stressed that central banks were much better prepared to cope with a global crisis than 2007:

“Central bankers have spent the past six years expanding their toolkit for dealing with a financial crisis  … The Fed opened what eventually became 14 swap lines in December 2007 to provide the global financial system with dollar liquidity as the subprime mortgage crisis stirred doubts about the quality of assets on bank balance sheets around the world. They were boosted as markets froze the following year.

The swaps were closed in February 2010 and re-opened three months later amid a squeeze in dollar funding due to the euro area debt crisis. Last December, the Fed extended the lines with the Bank of Canada, Bank of England, the European Central Bank and the Swiss National Bank (SNBN) until February 2014. The swaps allow the central banks to borrow in dollars from the Fed and then auction them at home.“

Niklas Magnusson and Evgenia Pismennaya (Bloomberg) quoted Russian central bank Chairman Elvira Nabiullina saying

“During the past five years, outbursts of volatility for various reasons have become almost a regular event … During that time, Bank Rossii has developed a whole system of instruments to support liquidity and smooth out fluctuations, which we can deploy again this time. We are constantly monitoring the situation to be able to react to it if necessary.”

Some government representatives made reassuring official statements as the deadline neared. Simon Kennedy, Aki Ito and Alaa Shahine (Bloomberg) reported that at the annual meetings of the International Monetary Fund and World Bank, which ended two days before the debt ceiling extension, policy makers from Japan, India, Russia and Saudi Arabia explicitly expressed faith in the ability of the US to pay its bills. However, the fact that they apparently felt the need to signal support and confidence rather added to overall uncertainty.

Ripples were felt almost everywhere.  Kennedy, Black and Ryan mentioned the example of Sri Lanka which unexpectedly cut its two main interest rates by 50 basis points to protect economic growth from the risk of a US default. They quoted Central bank Governor Ajith Nivard Cabraal:

““Even if the U.S. were to get their act together and get past the debt ceiling, I think the fact that the global economy has been put under so much stress, is something that many policy makers would not forget,” …  That’s going to lead to “various changes in the way central banks will perceive the safety and quality of investments”.

Markets

Markets sent clear warning signs. With a focus on CDS trading Tyler Durden of Zerohedge observed on October 15 that the US credit risk was worse than 2011.

In June 2011, The Economist had written:

“Trading in credit-default swaps (CDSs) on Treasury securities has picked up and the price of protection against default, as measured by the CDS spread, has risen … One-year protection is now almost as expensive as five-year protection. This is more often seen in distressed markets where investors are pricing in an imminent default than with otherwise healthy borrowers with long-term problems.“

And Abigail Moses (Bloomberg) had provided some details:

“Trading of credit-default swaps insuring U.S. Treasuries soared almost 80 percent as the deadline nears for plans to cut the nation’s budget deficit and raise the $14.3 trillion debt limit to avoid default.

Traders bought and sold 41 contracts in the week through July 22, insuring a daily average of $250 million of U.S. debt, up from $140 million during the past month, according to the Depository Trust & Clearing Corp. The country was the tenth most traded among the 1,000 entities tracked by DTCC, with 1,063 outstanding trades covering $4.9 billion of debt — a third of the total on German bunds.“

41 contracts is a small market as Matthew Klein (Bloomberg) pointed out on September 26, 2013:

“Almost no one outside of a few trading desks had even heard of credit default swaps before the 2007-2008 financial crisis. Then the hedge-funder John Paulson used them to make a lot of money while AIG used them to lose a lot of money and now everyone feels compelled to refer to them, even when discussing political issues such as the U.S. debt ceiling. …

This is all overblown. The size of the CDS market for U.S. government debt is so small and the trading volume is so thin that there really isn’t much one can learn from small short-term movements.

According to the Bank for International Settlements, the gross notional value of all the credit default swaps in the world at the end of 2012 was about $25 trillion. However, the notional value of contracts protecting against a default by the U.S. government is just a few billion dollars — or about 0.02 percent of the world’s total. That’s tiny.”

This view confirmed what The Economist had written in 2011:

“The illiquidity of the CDS market means it can be prone to misinterpretation. The vast Treasury market itself—for Treasury bills, Treasury bonds and other government securities—remains largely free of anxiety. America’s biggest interest payments occur on the 15th of August, November, February and May. Priya Misra, head of US rates strategy at Bank of America Merrill Lynch, says anyone who thinks America might default for several weeks this summer should sell a bond with interest due on August 15th and buy one with interest due on November 15th, which would result in the price of the first bond falling relative to the second. But, she says, neither market pricing nor the chatter of clients shows such a trend.”

But, 2013 is not 2011. This time, the Treasury market itself showed clear signs of distress, and it was not the only one.

Ken Sweet (AP) wrote on October 10 that overnight interest rates in the repo market, used by banks to fund day-to-day lending, shot up to 0.12 percent from 0.04 percent at the beginning of the month. As he explained one reason was that some banks stopped accepting some US Treasuries as collateral, or were requiring more collateral, to borrow.

Kennedy, Ito and Shahine  reported on October 14, only two days before the debt-ceiling was lifted:

“Rates on Treasury bills maturing through the end of the year rose last week as lawmakers sought a short-term compromise. Rates on bills due on Nov. 29 climbed 12 basis points, or 0.12 percentage point, to 0.16 percent last week … Yields on benchmark Treasury 10-year notes gained four basis points on the week to 2.69 percent.

While Treasuries aren’t trading today due to the Columbus Day holiday, futures rose after Senate leaders yesterday held their first negotiating session since the government shutdown began Oct. 1. Ten-year U.S. Treasury future contracts for December delivery rose 5/32 to 126 8/32, based on electronic trading at the Chicago Board of Trade.

The Standard & Poor’s 500 Index fell 0.5 percent to 1,695.03 at 9:57 a.m. in New York. The Stoxx Europe 600 Index slipped less than 0.1 percent to 311.44.”

Natsuko Waki (Reuters) observed:

“Over the past few weeks investors have generally remained sanguine, taking their cues from the last such cliff-hanger in August 2011, when equities fell and bond yields rose only to reverse sharply as lawmakers reached a deal.

But less than 24 hours before the deadline, investors are more inclined to recall the 2008 collapse of Lehman Brothers investment bank, protect their portfolios and try to profit from the risks.”

Investors

Few investors reacted as drastically as Fidelity Investments. Ken Sweet reported that the largest money market mutual fund manager in the US weeks ago had begun to sell all of its short-term US government debt that came due around the time the nation could hit its borrowing limit.

“Money market funds are a significant part of the U.S. financial system,” he wrote. … “[They] are typically ultra-safe places to park money. They invest primarily in short-term debt that can be easily bought and sold, such as U.S. Treasurys or commercial paper, debt issued by large companies to fund their day-to-day expenses. In a money market fund, investors expect to get back every dollar they invest.”

The Economist had already warned in 2011 that “in the event of a default at least one [money market fund] would probably “break the buck” (ie, fail to give the principal back to investors), threatening “a broader run on money funds”.”

Like other authors, Ken Sweet pointed to the effects of the nearing debt ceiling on the market for Treasury bills:

“The worry has other parts of the market showing signs of stress. Like Fidelity, other investors have tried to limit their exposure to U.S. government debt that comes due this month, with the heaviest selling occurring in one-month Treasury bills. The yield on the one-month T-bill jumped to 0.27 percent Wednesday, its highest level since the 2008 financial crisis. The yield was nearly zero at the beginning of the month.”

Traditionally, there is a large share of foreign investors  which is a stabilizing element in the market. However, their influence has been shrinking in recent years. As The Economist observed in 2011:

“More than half of Treasury debt is held abroad, principally by foreign central banks. Such investors would be unlikely to sell overnight since they have few ready alternatives. But they would be reluctant to hold as much in the future; some, like China, are already diversifying their reserves. After Fannie Mae and Freddie Mac, two giant mortgage-financing agencies, had to be rescued by the federal government in 2008, foreigners cut their holdings of these securities and have yet to raise them again even though the firms never defaulted.”

Recent developments confirmed this impression.  Niklas Magnusson and Evgenia Pismennaya (Bloomberg) wrote on October 16 that while China was still the biggest foreign holder of Treasuries, with $1.28 trillion at the end of July, “Russia, which has accumulated the world’s fourth-largest international reserves, has reduced its holdings of U.S. government debt by 25 percent from a record high on Oct. 31, 2010, to $131.6 billion in July, according to data compiled by Bloomberg.“

Other investors seemed less concerned. To quote Kennedy, Ito and Shahine once again:

“While Treasuries have become “mildly less attractive,” Reserve Bank of India Governor Raghuram Rajan said “we are not selling our U.S. assets, we are holding on to them.” Almubarak of Saudi Arabia, the world’s largest oil exporter, said “we are long-term investors” and “our long-term view is positive.”“

Even Russia appeared not inclined to act immediately:

““Our investment in U.S. Treasuries is a long-term investment so I don’t think there’s any major need for major revisions to how our reserves are invested,” Russian Finance Minister Anton Siluanov told reporters. “What’s happening today, I hope, is a fairly short-term situation.”“

Crisis dynamics

The latter remarks fit into the picture drawn by Felix Salmon earlier: No mass overnight reactions, but a less visible, less spectacular adjustment process with the danger that every new turn in this never-ending drama may end up in another global financial crisis.

The argument that trust does not matter in a world where investors have few alternatives to the US dollar is not new. It was heard for the first time almost 40 years ago when observers worried about OPEC’s investments of petrodollars. In those years, the share of the US dollar of global official foreign exchange reserves was over 80 percent. Currently, it is slightly more than 60 percent, with declining tendency.

Unfortunately, these long-term adjustments do not happen without frictions. Whenever the US debt drama enters a new stage short- and long-term, local and global effects overlap and interact making the outcome incalculable.

Currencies are the weakest spot. The Banker’s Umbrella recently offered an interesting view of the hierarchy of markets for currencies, bonds and equities which may illustrate the point. In his own inimitable manner he wrote:

“Currencies are the quickest and smartest kids in the class.  … The currency markets cotton on to stuff quicker than anything else, so understanding the movements there will give you a clearer picture of the overall market environment. The reason currency markets are the quickest of cats is because they are massive. I mean HUGE. … A market doesn’t get any more efficient than the currency markets.

Not many people know this since equities tend to get the attention in the mainstream media, but bond markets dwarf equity markets. … If nothing is happening in the currencies, then chances are bond markets will know. … Just remember to watch both the longer bonds and the shorter bonds, are yields going up or are they going down?

Finally it’s equities. … They are the last to comprehend what’s going on.”

And, referring to the US situation:

“Let’s take a case in point: The current US Government Shutdown this week. You’re seeing a clear weakening in the US dollar against the Euro. This shows that the currency markets are a little more than worried about what could happen in the US as they sell their dollars. Bond yields are uncertain, don’t really know if they are coming or going so they aren’t sure of what’ll happen … As for equities? Well they aren’t worried, no big moves and the volatility index (VIX) often referred to as the fear index is still at low levels.

These kinds of situations: Currencies worried, bonds uncertain and equities relaxing are not that common occurrences. In this environment, I’d be very cautious indeed.”

While I am writing this, markets once again seem to forget about tapering and prepare for another round of debt impasse and political showdown with more turmoil for the US currency to come in February. Other things unchanged, the main beneficiaries will be rival currencies such as the British pound, the Australian dollar and, above all, the euro, which in the longer run may be joined by the Chinese yuan and other emerging candidates.

So, to answer the question in the headline: Yes, the US debt drama has a bit of both, soap opera and Lehman quality, which is a most dangerous mix for the world economy.

The final word in this matter shall be given to Russian central bank Chairman Elvira Nabiullina for today. In an e-mailed response to questions from Bloomberg she wrote: Endangering the dollar’s standing “seems completely insane”.

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One Comment
  1. Very good summary of the inevitable effects of financial globalization. See also: When risk is sticky | David Crum | FTAlphaville http://ftalphaville.ft.com/2013/10/31/1681502/when-risk-is-sticky/

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