Debt Ceiling Dilemma: The Foul Choice Investors Are Facing
Ben Bernanke has managed to combine both negative returns and risk into a very unattractive investment brew.
For the record, I still believe that there will not be a breach of the debt ceiling and no overt default for the US. Things will be worked out in the nick of time, like they always are.
However, the media is full of articles wondering about what "investors" might do in response to a US default and/or credit downgrade. What will happen to Treasury prices? Will they go down as investors dump them en masse in response to a credit downgrade forcing interest rates to climb?
It’s a big question and the most likely answer is “No, not really." Partly because these so-called investors have been well-conditioned to believe that another bailout is always around the corner, but mainly because they have nowhere to go.
The big money is trapped.
For example, imagine that you are in charge of a money market fund with $100 billion under management and your job is to both cover your expenses and assure a return for your depositors and you are heavily invested in US Treasurys. Or imagine that you are in charge of a public pension with $200 billion under management with the same basic concerns of managing expenses and delivering returns and a heavy exposure to US Treasurys but with a much longer time horizon.
In either case, in light of the possibility of a US default, what would you do? Where would you put your money right now if you were suddenly of the mind that the $50 billion you had in Treasurys should be placed somewhere else? In reality there are not that many places to quickly move such large sums of money. Further, there might be fiduciary restrictions that limit your investment options to regions, securities types and/or ratings grades or there might be a minimum liquidity requirement for the investment pool.
So let's imagine that you have to make very large and important financial decisions and that you have to put your money to work; it's either an actual fiduciary or operational requirement of yours. An excessive amount of cash is not an option and neither are hard assets such as land, gold or silver. Where would you put it? What realistic options exist? It turns out there are not that many.
The Treasury market is the largest and most liquid in the world, by far. For many big money funds there really aren’t any realistic options other than the Treasury market, and this present reality will limit the market reaction to any downgrade.
A Foul Choice
With interest rates on "safe" sovereign debt at or near zero on the short end, and well below the rate of inflation on the long end, safe bonds offer a negative real yield (meaning a yield below the rate of inflation). This is a compounding disaster for everyone but especially for pension funds with their longer time horizons. Worse, we now know sovereign debt can no longer be considered safe (even the US is facing a downgrade threat) -- which means that on a risk-adjusted basis, the returns are even more unattractive than the negative real yields on offer.
On the surface, the choice that Ben Bernanke has engineered for investors is between guaranteed losses via the miracle of negative real compounding and taking on more investment risk. But he’s managed to combine both negative returns and risk into a very unattractive investment brew.
Most big money funds have opted to take on more risk rather than suffer such low returns (and who could blame them?) and have done so by going to where the yields happen to be. This means buying up corporate paper and European debt, both of which have far more risk than their nominally more attractive yields would imply. For individual investors, especially savers and those living on small incomes tied to interest rates, the negative interest rates have been especially difficult if not an outright disaster.
Once again, we can thank Ben Bernanke et al for driving interest rates into punishingly low territory forcing everyone with a desire or responsibility to save and invest to either lose to inflation or to take on more risk.
Part of the goal behind ultra-low interest rates was to drive money back into the stock market, which the Fed has been specifically and openly targeting in both word and deed. It is a well-known fact that low interest rates are supportive to the stock market and so far that strategy has worked.
On the flip side of this success is the fact that a lot more risk has been forced into the system. When prices are artificially distorted to the upside for stocks or bonds, then it is axiomatic that risk becomes mispriced.
Having to choose between mispriced risk and negative returns is truly a foul choice indeed.
The Deficit Theater
All of this brings us to the current sad state of affairs now put into high relief by the deficit talks in DC, which more properly should be viewed as political theater rather than a legitimate attempt to square the federal budget up with reality. If the talks were truly legitimate, then on the expense side everything would be on the table, especially and including defense spending and a balanced budget amendment would not be a source of contention but a mutually agreed upon goal.
Instead the Democrats are willing to entertain higher spending cuts in the vicinity of $250 billion per year as long as they can have a debt ceiling increase that would get them safely past the 2012 elections. Conversely, the Republicans as represented by John Boehner are ready to concede to relatively meaningless spending cuts in the vicinity of $100 billion per year as long as they can force the debt ceiling to be an issue for the 2012 election cycle:
Mr. Reid, the Senate’s top Democrat, was trying Sunday to cobble together a plan to raise the government’s debt limit by $2.4 trillion through the 2012 election, with spending cuts of about $2.5 trillion. He would seek to avoid cuts to entitlement programs, but it was unclear how those savings would be achieved.
Notably, the plan does not currently contain any new or increased taxes, an approach that many in his caucus would probably balk at.
The contours of Mr. Boehner’s backup plan were far from clear, but it seemed likely to take the form of a two-step process, with a short-term increase in the debt limit along with about $1 trillion in cuts, an amount the Republicans said was sufficient to clear the way for a debt limit increase through year’s end. That would be followed by future cuts guided by a new legislative commission that would consider a broader range of trims, program overhauls and revenue increases.
(Source – New York Times)
Just looking at the proposed levels of deficit reduction, whether it's $1 trillion or $2.5 trillion, neither plan will drop the deficit enough to prevent the US from slipping deeper and deeper into the red. The true drivers of the debate, such as they are, center on political advantage and power. Count us among the unsurprised at this turn of events.
It would be nice -- essential even -- to have enough information to go on to really assess the true dimensions of the deficit reduction proposals but, even for a committed analyst like myself, there’s just too little detail to make a decent analysis of any of the competing packages.
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