Market Reports
Will the US go Bankrupt?
Niv Dagan - 28 July 2011
The USA, the powerhouse of financial markets is in danger of losing its most possessed identity – its AAA credit rating.
This is a big deal.
For many decades, the US was seen as a “safe haven” for offshore funding and the US Dollar, a benchmark for all other global currencies. China was aggressively buying US treasuries in the 1990’s and 2000’s, European investors were purchasing US corporate bonds and America was flying. However, this all changed in 2008/09, when Bear Stearns and Lehman Brothers collapsed, AIG was close to default through their exposure to the subprime mortgage market and no firm was “too big to fail”.
The underlying issue has now turned its attention on fiscal, rather than corporate debt – putting the Lehman Brothers collapse in 2008, as a small pin adjacent to a 747 Qantas jet.
The issue at hand is underpinned by the over spending and excess borrowing of the US government. The Debt to GDP ratio of the US is now at 98%! This has led to the US “Debt Ceiling” being raised from $49 Billion in 1940 to $14.3 Trillion in 2011.
In theory, each working American now owes the government over $180,000....
That’s a hell of a lot of money, especially for the average American.
US Debt Ceiling
So what will happen if the US debt ceiling isn’t raised next week?
There are some very good reasons why this issue over the US debt limit is hurting investor sentiment around the world. The US government is a AAA-rated credit. There are thousands of other credit instruments (both in the US and around the world) that are priced off the debt of the US government.
So if the debt ceiling is not increased by 2 August, the US government is in technical default and this would threaten the AAA rating of literally trillions of dollars worth of assets around the world. Hence the market’s nervousness while the impasse continues.
A decision to cut the government’s credit rating would likely increase Treasury rates by 60 to 70 basis points over the “medium term,” raising the nation’s borrowing costs by $100 billion a year, JPMorgan Chase & Co.’s Terry Belton said. It could also hurt the rest of the economy by increasing the cost of mortgages, auto loans and other types of lending tied to the interest rates paid on treasuries.
Yesterday, the markets showed little debt ceiling concerns, as seen in 10-year Treasury note yields hovering around 3 percent, below the average of 4.05 percent over the last decade, and the average of 5.48 percent when the country was running budget surpluses between 1998 and 2001.
The debt market (the best indication of whether the US will default) is indicating to us that the US will not default and the US will restructure its debt for now. While the threat and impact of a default would likely cause a great deal of confusion in the short term, the likelihood of it happening and having a lasting impact is a low probability outcome.
Most countries default because investors decide they no longer want to lend to them. This sends bond yields soaring. Indeed, rising bond yields provide the most accurate warning of an impending default (or bailout, in this day and age).
The dispute over plans to cut the U.S. federal deficit has stolen investor attention away from an earnings season that has produced higher-than-estimated results at about 81 percent of S&P 500 companies that reported so far. Shares of industrial companies helped lead declines last night after a Commerce Department report showed durable goods orders fell 2.1 percent.
“It’s a tug of war between the headline risk of the debt ceiling issue and earnings,” Matthew DiFilippo, who helps manage $1 billion as director of research at Stewart Capital Advisors LLC in Indiana, Pennsylvania, said in telephone interview. “The volatility may create buying opportunities because corporate earnings are coming in strong."
The gridlock over the debt limit “highlights the sheer difficulty” lawmakers are having coming to agreement, he said, which has prompted S&P to shorten the time frame over which it wants to see major cuts. The supposed looming US default has entirely different causes. It’s based purely on politics. There is still demand for US debt and bond yields are not signalling imminent default.
The point is, I don’t think you should overly worry about the impact a US debt default would have on your portfolio…not yet anyway. The time to worry is when the market imposes the discipline (via rising bond yields)... not the politicians. That event is still a few years away.
So where to from here?
Over the next 3 days you will see a large “short covering rally”, which will send US equities up over 200 points. Obama and the Republicans will reach an agreement before 2 August and global markets will rally next week. So buy now.
The focus will then turn back to Sovereign debt issues in Europe and the US reporting season.
Happy Trading,
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