The Road to Default: Puppy Power!

Although Congress can technically dilly dally until August 2nd to come up with an agreement and raise the debt ceiling- markets have anticipated the inevitable. They haven't sat back and decided to wait till August 2nd to panic- they are already in "oh shit" mode.  On this note a recent CNBC interview with David Murrin suggests that I am not alone:

A U.S. default isn't a matter of "if" but "when," David Murrin, chief investment officer at Emergent Asset Management, told CNBC. "It's inevitable that the U.S. will default—it's essentially an empire which is overextended and in decline—and that its financial system will go with it," he said.

Uncertainty about what Congress is going to do has forced investors to assume that Congress will screw it up.  Steven Hess of Moody's explains this as "event risk" and today suggested that the United States eliminate its statutory limit on government debt to reduce uncertainty among bond holders.  

"The current wide divisions between the House of Representatives and the Obama administration over the debt limit creates a high level of uncertainty and causes us to raise our assessment of event risk," Hess said.

This additional "event risk" is just one additional factor that encourages ratings agencies to downgrade the United States AAA credit rating. 

Unsurprisingly enough, we have already seen the Dow Jones fall 1.1% today. Surprisingly, Treasury yields have remained unscathed. Furthermore, there has been an increasing capital "flight to safety" as Gold hit a new high today. Investors are just chillin' and waiting for the news that will trigger the dumping of Treasuries. I have a feeling that this is the present situation because investors aren't buying Treasuries, but they're also not selling them, instead we see the flight to safer assets from stocks directly to Gold and Silver. I will be following the news as it unfolds with both ears perked ready to hear the verdict. This is the casey anthony trial for the financial markets.

Who is going to save the world? Will it be a bunch of cute puppies fighting crime and licking the face of someone in a state of post traumatic stress? Unfortunately, i don't think any amount of cute puppies will be able to cause congress to agree on a sustainable and credible debt deal in the near future.  That is why I ask who is going to save to world? If not cute puppies- then who? 

Timmy G of the U.S. treasury? Benny B of the Fed? Or will our nation just rise up like Chris Angel and produce a resolution out of thin air?

Keep shufflin'

Steven J.

The Road to Default: Deep DooDoo

Okay so what is the situation at hand? Well the inevitable default of the United States of course.  The U.S. will default regardless of whether Congress raises the debt ceiling. You may be thinking the following: But how can he say such a thing? Is there anything we can do to stop it? There is no way that can be true!

Let me convince you that we're in deep shit.

First: Look at Italy. Until this past week they were considered a safe haven for bondholders. Then their eurobonds jumped up to 6% because investors got spooked. Nothing happened that would suggest that they are in fiscal demise. There is no real political instability or real danger of default and Italy's banks are relatively well capitalized with mostly retail deposits.
The U.S. on the other hand has had petitions being signed by influential economists and businessmen urging congress to raise the debt ceiling to come to an agreement.  We also have had default and debt recently come to the center stage and center of attention. In financial markets, anything that even gets a little press ends up being way worse than initially anticipated. For examples of this just look at the subprime mortgage market and how early warning signs were easily dismissed.

In Charles Poor Kindleberger's famous book on the history of financial crisis, one of the most tell tale signs of a major breakdown looming is when a central banker or someone important gives an early warning. The example we can draw from is in 1996 when then chairman Alan Greenspan warned of "irrational exuberance" to describe the tech bubble.  In terms of prescience we have seen numerous warnings from Benny Bernanke about our debt buildup.

No matter what happens the U.S. will default. Cautious investors should get the picture if they haven't already that now is the time to cash out and see what happens.  I could be wrong- but the turbulence that will ensue regardless as Congress fights over what to do will not be worth the hassle.  My game plan would be to buy back in when yields spike and they could spike by quite a lot. S&P was even recently taking about downgrading U.S. treasuries to AA status regardless of a debt ceiling negotiation.  Yields will spike. I promise you and now you have to promise me to keep dancin'

Steven J.
  

The Road to Default: Debt Ratio Comparison's With Previous Episodes

In 2009, Carmen M. Reinhart and Kenneth S. Rogoff wrote a book titled ,"This Time Is Different" about debt and financial crisis. One of their charts will provide a benchmark for us in our analysis.  This chart can be found on page 121 of the book and shows the ratios of public debt to revenue immediately preceding an external default.  For Africa the external debt/ revenue ratio was 1, Asia it was 1.5, in Europe it's 1.6ish and for Latin America its closer to 3. As the following chart explains our current ratio in the United States is around 1.7ish which is higher than in Africa, Asia and Europe at the time of an external default.

Additionally the chart in "This Time Is Different" also compares the ratios of total debt to revenue at the time of the default.  For Africa is was 2.6ish, in Asian countries the ratio lies around 4, in Europe it hovers around 3.75 and for Latin America around 4.6ish. As the following chart shows, we are considerably past this doomed territory with a public debt-to- revenue ratio of around 5.61 and climbing. The following graph I did in R because it just seemed easier. 

 So the lesson's learned today are that by history's benchmarks the U.S. is way past the point of no return and all we can do is hold on for the ride of a lifetime or prepare for the Federal Government to cut spending by a large enough amount that real GDP growth will most likely slow to a stall. It's a lose-lose situation. Prepare for pain, but keep dancin',

Steven J.