Rating For Godot

By: Michael Ashton | Tue, Jul 26, 2011
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I have said several times that I expect the debt ceiling debate, as heated as it has become, will be resolved "just in time" and will be followed by loud back-slapping about the glorious bipartisanship that has been displayed by avoiding this disaster of our own making.

However, I must say that as this debate gets more and more surreal, it does make me scratch my head a bit. President Obama took to the airwaves last night to sternly remind us...what? That the two sides in Congress might have to accept something that doesn't fully satisfy either side? He had no new suggestions for reaching agreement - in fact, he muddied the waters by proposing something (tax increases! We don't have enough of your money to make ends meet!) that both sides have stopped discussing as part of a solution. To add to the sense of unreality, he urged people to contact their legislators...and most of the websites of Members of Congress promptly crashed. Well, that's one way to avoid hearing from the People!

It seems like the Reid plan is in the lead, and though it uses some gimmicks (like counting savings from "winding down the wars in Iraq and Afghanistan," which isn't really up to Congress although I suppose funding our soldiers is) those gimmicks are similar to ones Republicans have used in the past. I am most skeptical of the "$400bln in interest savings" in that plan, when interest rates are very likely to rise; my guess is that he takes the projected future rise in interest rates that is in the budget and lowers the projection to get a "savings." Heck, if it was that easy we should just lower that assumption a lot further and get the whole $2.7 billion! It sounds like he has been studying pension accounting.

Still, a budget agreement, even one with gimmicks, that makes real spending cuts and doesn't raise taxes much or at all is a huge win for the country. Smaller government (let's not, however, call it "small" government) leaves more for everyone else. In reducing a deficit, it is the method that causes the lowest negative impact immediately (since tax increases have a larger multiplier than spending cuts) and in the medium term actually bears a dividend in terms of faster overall growth as the private sector uses those resources more effectively.

Clearly, even with a huge deficit-reduction plan (and the plans being discussed don't qualify; the $2.7 trillion or whatever is spread over a decade and involves a lot of questionable assumptions anyway) the country faces enormous challenges, and growth will be tepid at best for a while - and, if there are real cuts to government spending, temporarily negative in the near future. This is not encouraging with the job market still flatlining - the "Jobs Hard to Get" subindex in the Consumer Confidence report rose again, to 44.1 (the overall index surprised on the high side but remains very low at 59.5).

So...what about a downgrade of the U.S. credit rating? Let me rephrase: so what about a downgrade? Anyone who evaluates the US market on the basis of rating agency markings, and avoids a AA+ or AAA- instead of a AAA+, is seriously confused. It makes some sense to rely on ratings agencies when they downgrade a country to less-than-investment-grade (simply because investment managers need to have a bright line somewhere in the investment mandate that tells them what they can and cannot invest in), but the list of AAA companies that ended up failing - the most notable being Enron - should make any investor skeptical of the ratings in the first place. Oh, and any investor who is worried about the debt ceiling should be aware that Fannie Mae and Freddie Mac debt, about $1.5 trillion of it, is not included even though these are now under conservatorship. Neither are any of the government guarantees of mortgages and money funds and banks that were put into place in the crisis. Nor are unfunded Medicare and Social Security liabilities. All of these are debt as well, especially the FNM and FRE debt - suggesting that one way to resolve the impasse is to simply re-class obligations so they aren't under the definition of the cap. I would not be the slightest bit surprised if that ended up being part of the final deal.

But, as I have pointed out a-plenty, a downgrade is not the issue here. Any 'default' for a sovereign issuer of currency can only be a technical or political situation, because the Treasury can always simply print currency to pay the bills: physical currency is not included in the "public debt subject to limit." For that matter, neither is it subject to limit if the Fed 'pays' for Treasury expenditures or interest by simply crediting the appropriate accounts with electronic money. Now, in both cases it would be practically hard to print the amount of money needed to avoid default quickly enough, because we chew through an amazing pile of money every day just in interest and principal payments - but that's an engineering challenge, not a financial challenge. Any sovereign issuer of its own currency (which leaves out Europe) is able to be AAA until it decides it doesn't want to pay. So the ratings agencies aren't measuring financial stress, but the I.Q. of its politicians. On that basis, we should have been BBB long ago.

Frankly, I don't think the market goes particularly crazy if a deal is not struck by the "deadline" - and that possibility is probably the scariest thing a Congressman could think of right now. Irrelevance of the political circus? What if the U.S. rating fell in a forest and it made no sound?! Like I say, we already know these clowns are doing their act; do we really care if the funny car breaks into pieces when they try to stuff it too full? I'm butchering metaphors here but I think you get the point.

But the scary brinkmanship in debt ceiling negotiations is starting to have an effect on markets. As I have said, we're all waiting for the debt ceiling to pass so we can sell the pop in stocks and/or in bonds, but ... at least occasionally we are asking the question whether it's possible that the deadlock may not be broken any time soon. As a result, stocks are having trouble making headway (the S&P fell -0.4% today) and the dollar index is the lowest it has been since May...which in turn was the lowest since 2008. The dollar index never broke and held above 76.00, and now is approaching the May lows; this is pretty negative. Bonds are doing okay, because one effect of an impasse would be a significant decrease in the pace of the government bond auctions (presumably, however, they would continue to have auctions since maturing issues would lower the debt subject to limit, allowing a similar amount of debt to be auctioned without violating the cap). But I don't think I'd play the 'Treasury scarcity' card when there is ~$9.3 trillion in marketable Treasury debt out there. Again, we're all just waiting to sell the pop when there's a deal done (although it is less clear in Treasuries than in equities, I think).

On Wednesday, Durable Goods Orders (Consensus: +0.3%/+0.5% ex-transportation) and the Beige Book will be released; we all know by now, however, that eyes will be turned towards Capitol Hill - expectantly, resignedly, but turned in that direction nonetheless.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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