US Default?

China notes that the United States is “playing with fire” if it agrees to default on its debt. Quite unwittingly and a bit reluctantly this will most definitely force countries like China to try to prop up the USD by purchasing more and more of the defaulted treasuries as they get dumped (mostly by US domestic holders of such treasuries). What a debt trap! China seems to have invested as much as 70% of its $3 trillion foreign currency reserves in US Treasuries! The posture taken by the Chinese is all about their concern that the money that they have invested in US Treasuries is safe, the reality is that the US wouldn’t care as much even if a “technical default” causes a fall in the USD. But countries exporting to USA would get killed – therefore in order to protect their exports, countries such as China, Brazil, even India, might be prompted to buy more to help hold down their currencies from appreciating.

The picture on the right shows the distribution of the lenders to the US Government. The main worry of the US would be that such a technical default would likely cause a ratings downgrade which would in-turn increase funding costs; raise interest rates; depress house prices and slide the economy back into a recession. And of course crash stock markets and shoot up gold. US benchmark 10 year Treasury yields are already hovering near their historic lows of 3%. Now, just what trigger would these notes need to start yielding higher again? A massive sell-off?

Assorted articles on the internet (I’ve pulled most of the ideas for this post from Reuters) seem to be placing the chances of a US default at near zero and many people are obviously dismissing the idea as ludicrous – but stop and think about what would happen if this really plays out like this. We’d know by mid August when some chunk of treasuries are up for redemption and payments. The chart on the top (click to enlarge) shows the US debt levels and the corresponding increasing in its debt ceiling levels. Now, the US Government cannot borrow more than its debt ceiling level and since it breached that level in May 2011, the Senate needs to vote in an increase of the debt ceiling. The reason why people are calling for a “technical default” is that a delay in voting for raising the debt ceiling may give time for economic forces to play themselves out and things to settle and solutions to emerge. Like a cooling off period. Before upping the ceiling. Most certainly it sounds like the political opponents of President Obama trying to generate real bad press and image for him by making the US Government “default technically” and then coming in to the rescue by voting to support the resolution to up the ceiling. That may be why the Treasury Secretary and the Fed people are saying that the results to the world economy will be disastrous if the US defaults.

While the idea of the US defaulting does indeed appear crazy, nitpickers are therefore qualifying a “technical default” as being a different situation as compared to a real “failure to pay” kind of an event. The latter is catastrophic. The former is more like a pause that people do when enjoying a lavish luncheon buffet. They pause for breath, beam at their table-mates and reach out for their wine or water to catch their breath. Continuous eating, while supplying loads of calories, can be quite tiring. It also makes you a glutton. Take a look at this chart that I’ve sourced from Reuters (US online edition). How long can someone keep eating and eating and eating?

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The Bond Bubble

The bubbling stories going around this week in the financial blogosphere have mostly centered on the heady climb of US treasuries. In fact the topic has been quite hot the past month but the din is getting louder now. Comparisions with the dot com bubble and the housing bubble have started doing the rounds. The yield on the 10 year US paper is currently around 1% now. Which means that if you freeze the frame today, it will take a hundred years for the interest component to add up and match the price you pay for such bonds today. The P/Es (inverse of yield) of the no-brick and no-mortar tech companies were also in the heady hundreds during 1999-00. I don’t have too much of a view since it’s all happening outside of our shores. The Small Investor writes about it here as also the links I’ve listed below: it’s important enough for us to pay attention since we have NOT decoupled ourselves from the west. It’s actually the FII money that’s driving up our local markets here. Hot money.

  • FT Alphaville on the conundrum that equity prices and bond price are now moving in step. i.e. UP!

Logically, I’d guess that the bond market is bigger, more liquid and less amenable to manipulation. So, if the bonds and the stocks are sending out conflicting messages, should one not trust the former?

However, are bond markets better predictors of the economy? I think not: since nominal GDP growth and interest rates are both driven by inflation. Correlation is NOT causality. It’s a mistake many make – if two lines A & B move in tandem, that does not necessarily mean that A and B have a causal relationship. There could be a third factor C which is driving both A & B. So, bond prices are ↑; equity markets are ↑; economic data (US) is ↔. Thats the confusion. 

  • A website called bond-bubble (what else!) has come up and the graph on it’s homepage is quite telling.

It shows the super steep rise of US public debt – almost a parabolic rise. To me this looks similar to the rise of the Chinese stock market. That looked parabolic as well ( y = 4 * A * x↑2) and it could not defy gravity. But can US debt come crashing down? Maybe – if the currency crashes.

  • That seems to be awesome news for the gold bugs! It makes the case that the bursting of the bond bubble will pave the way for a massive upsurge in gold prices. The article notes that the yellow metal shines brightest in three situations – “heightened economical/financial risk; outright inflation and/or deflation”. And therein makes the case for a coming Gold bubble! Marc Faber,  (who keeps telling people to buy gold) has been bearish on treasuries right through the start of April but no one seems to be listening.

 TULIP SOUTH SEA RAILROAD ROARING TWENTIES → POSEIDON → JAPAN → DOT COM → HOUSING → BOND → IS IT GOLD NOW? 

This is making people like me (the “half informed”) even more nervous now. Ignorance is bliss – part knowledge is most painful. Anyways, the local markets are frothing on all the money that’s coming in from the US. The Fed there is busy buying up treasuries and sloshing money in their system (to buy the bonds, the Fed has to release money by paying whoever is holding bonds). They’re doing it by working their printing presses overtime spooking inflation. But I guess the game with inflation is that if you whack it too much too fast, the thing just snaps and the party careens towards deflation. I wish I had paid more attention during my economics classes. But to me it sounds logical that what comes in, goes out. So, this money will go back from where it came (at least in the interim). And all will fall down.

Though there is some more ground for the NIFTY to cover. That’s what the “experts” here are saying. The market isn’t fully stoned yet. It’s just started rolling the weed, maybe a few drags….let’s stop hallucinating. In 2008 so many of our local “experts” were shouting out that India is decoupled and that the housing bubble will not effect us. Even politicians had joined the chorous. De-coupled my moon. We are as joined to the US hip as our big bro in the vicinity.

Maybe I’ll be able to call the top.

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