The Road to Default: We Crumble Like A Cookie

What should we be expecting when the United States defaults and how will this unsavory process unfold? Well for one thing anticipate the downfall with a downgrade in the credit rating.  According to recent Bloomberg article in the event of a U.S. default, Standard & Poor's would lower its sovereign top-level AAA ranking to a D, and Moody's would lower it to the Aa range.   The lower credit rating's would be absolutely disastrous for the bond markets because corporate bonds usually move in sync with treasuries and a default would lead to a sudden reversal of this standard procedure.  In the graph we compare interest rates on Moody's Aaa Seasoned Corporate Bond's with both the 3 year and 10 year treasuries.  Notice that Moody's rates are currently around 5% and we're now paying below 1% on our three year treasuries.  Now logically consider if Moody's downgrades our debt to Aa status- in the best case scenario we see a rise by at least 4-5% in interest rates.  Why will the rise be so sudden? Many insurance companies and pension funds, by internal mandate, hold only the absolute safest of securities. This means AAA only ratings are allowed.  Once treasuries get slapped with a lower rating- these funds will be forced to sell causing a massive decline in bond prices and an unprecedented spike in interest rates.  This spike in interest rates would make the most liquid market on the planet freeze up causing both a financial crises and a political one as well. For one, medicare and social security payments would have to stop. Second, treasuries are held on banks balance sheets as collateral, if they lose an unprecedented amount of value, we could see a banking crises as even cautious institutions may find themselves in an unhealthy cash position. Even U.S. credit defaults (CDX North American Investment Grade Index) swaps have climbed to their highest level since October! This is certainly not the beginning of this story, but it ain't over till the fat lady sings.


keep dancin'


Steven J.

Revised to be relevant and useful: TIPS and Inflation Expectations

In a previous post  I calculated expected inflation using some bond that was maturing in 2012 but we want to get a more accurate (and relevant) picture of expected inflation.  To do this we can go to the Federal Reserve and observe statistical release H.15 which are selected interest rates.  For example, 10 years from July 22nd expected inflation is:

E(p)= i - ir
Where E(p) is expected inflation,
i - nominal interest rate ( interest rate paid on nominal treasuries)
ir - real interest rate (remember the inflation index bonds are supposed to reflect these)

Looking at the statistical release if we want the 10 year inflation expectations we must look at the 10 yr bonds.  We will find that for July 22, 2010:

i (Nominal Treasury) = 2.9%
ir (Inflation indexed Treasury) = 1.78%

2.96% -1.78% = 1.18% 
E(p) = 1.18%
Therefore expected inflation for the next 10 years as of July 22nd is 1.18%