These days the headlines ‘calamity’, the ‘disaster”, ‘financial Armageddon’, and the”Titanic sinking” are used to describe what will happen if Congress refuses to pass the debt ceiling authorization in a timely manner. If the U.S. government defaults on its sovereign debt obligations and other payment obligations, there will be an immediate downgrade of our trillions of dollars of debt to something less than AAA. This will cause enormous upheaval and increased interest costs, thus exacerbating the already enormous burden of debt the country shoulders. These events could lead to an uncertain chain reaction of cascading financial upheavals around the world; events that no one can predict with any degree of certainty other than certain that none of the ensuing results will be good. That is as succinct an explanation as I can provide.
How far is this from the facts on the ground, though? Normally when a credit is put on watch for possible downgrade there is a precipitous drop in price and spike in yields. What happened to US Treasury market when the two leading independent credit agencies, Moody’s and S&P first started warning about the impending credit event?
As you can see from this chart, the US Treasury price continues to rise in value as the rating agencies issue one warning after another. The various warnings by the credit agencies have the opposite effect on price. When rates go down, long-term debt instruments go up in value. The U.S 30 yr Treasury bond has steadily risen in the face of these downgrade warnings. This is the exact opposite of what normally happens to the price of debt instrument that is hit with downgrade warnings. The calamitous consequences of a U.S. debt downgrade drive a flight to safety, to the very instrument that is being downgraded. In other words, the more unlikely repayment of the debt obligation is, the more people want it. This kind of contrary cause and effect can only be explained by the following scenarios.
1. The prospect of not getting paid by the U.S. Government is so calamitous that stocks and other risk assets sink in value and people run to the safety of the very asset class, US debt that is getting downgraded. That of course makes no sense whatsoever. This is analogous to a lifeguard at the beach shelling ,”shark!”, and everyone running into the water instead of out of it.
2. The bond market really doesn’t believe there is any chance whatsoever of not getting paid by the U.S since we can print money. What’s the problem? It’s just that most risk assets classes around you are worth less and by consequences U.S. debt goes up in relative value. In that scenario being late on payments is worth more than the stuff that pays on time because it’s just a matter of time before the economy gets worse and good businesses deteriorate in the near future. Carrying that logic to its logical conclusion, let’s say U.S. debt obligations delay payments for extended periods. The economy goes into contraction, markets are in shock, and the value of the defaulted U.S. paper skyrockets in value. The less likely we are to pay interest, the more desirable the debt obligation.
If this topsy-turvy Alice in Wonderland logic makes sense, why not default now? In fact instead of paying interest on the debt, charge buyers to own the paper. You want our worthless debt obligations, you have to buy them. Pay up, you pay us interest, to the US Treasury for the right to have the US government not honor its obligations. The louder you scream “sharks!” the more people run to safety of the water.
I don’t believe this. People are not that stupid. Even if the rating agencies declare U.S. debt something diminished from Triple AAA people are just not buying it. Until there is a better currency than Treasuries it won’t matter much what the rating agencies determine the paper is. The U.S is still the safest broadest base of currency in the world and that alone makes it AAA. When people start really running into the sea when the lifeguards warn of sharks, then that’s the time to abandon the boat but not now.