Totally Disconnected: US Government Risk, Ratings, Bonds and Equities

As part of his seemingly ongoing program to remove systemic risks within the financial and corporate matrix, Ben Bernanke suggested yesterday that the Fed might start buying long-term treasuries shortly. That proposition might appear ridiculous (i.e. the government buying its own paper) to many critics of the bailout schemes; but given the total disconnect today between the essential constituents of the financial markets, successive failures in monetary policy might well lead to the most ridiculous proposition of all: the Fed buying equities. And here’s why.

On Tuesday, shortly after Standard & Poor’s reiterated its “AAA” rating for the United States, credit default swaps spreads for 10-year treasuries firmed to 55 basis points, from a 60-65 range a few days earlier. However, as one CDS price-maker warned, perceptions of US government risk could change dramatically if the latest Obama stimulus plan begins to reveal serious flaws. Firstly, as Paul Krugman pointed out in an opinion piece in the New York Times (January 8, 2009), the $775 billion rescue package falls far short of what is needed; the “output gap”, i.e. gap between what American can produce and what it can sell, could be as high as $2.1 trillion over the next two years and, according to Mr. Krugman, the Obama prescription is simply not enough. Secondly, it is important to realize that only 60% of the Obama plan envisages public spending; the rest consists of tax cuts and, as many economists rightly point out, cash subsidies.

Furthermore, it is this writer’s view that the dynamics of massive public spending (financed by debt) are being misinterpreted by Washington lawmakers and regulators, and erroneous historical parallels are being drawn. In 1946, for example, US government debt had risen to a then-unprecedented level of $246 billion. But victory in the Second World War, against fascism and, with respect to Western Europe, against communism, enabled America to consolidate and expand markets for American capital. Shortly after the War’s end, the Marshall Plan, singed into law in 1948, ensured that trade, industry and consumer demand in those very same markets rapidly picked up real momentum. In brief, stimulus funds opened up huge external markets for domestic corporations, for industrial goods, for agricultural produce and for technical expertise.

But what identifiable productive business activity will be generated after the roads, railways and bridges are constructed, or re-constructed? How does President-elect Obama plan to eventually reduce the budget deficits and national debt?

One need not look to S&P for answers. The rating agency has repeatedly clarified, in position papers available on its website, that the “AAA” rating reflects an extremely low risk of default at maturity, not a mid-stream impairment. S&P did warn that the Obama plan “will lead to a noticeable deterioration in the US fiscal profile.” But what exactly is the logic of reiterating a superior credit rating when the agency’s spokesperson acknowledges that “there are a lot of unanswered questions”? CDS quotes are indeed reflecting those “unanswered questions”; Spreads on “AAA” credits range from a low of 25 bps, for the highest-rated sovereigns, to a high of 250 bps for investment-grade corporate credits.

The non-investment-grade markets are following their own course altogether, with default risk insurance for BBB- (and lower) issuers ranging from 600 to 1300 bps! Similarly-rated sovereigns are priced anywhere between 350 and 850 bps! S&P analysts have failed, thus far, to provide any useful insight into the de-linking between credit ratings and yield spreads. And cynics have starting ignoring the rating process altogether, with even seasoned analysts now suggesting that S&P news releases can no longer be taken at face value.

But for the Fed, this disconnect is, by itself, a hitherto-unrecognized systemic risk of a different kind; akin to the case of the Little Dutch Boy having his finger in the dike, while the dike is crumbling around him. Since CDS spreads for 10-year treasuries are likely to breach 100 bps by the second quarter, it is time to cautiously start building short positions (IEI, SHY, TLH) in treasures this week. And given the basic flaws in the Obama stimulus plan, this writer retains his shorts on equities (DIA, QQQQ, SPY), while being conscious of a possible transition from the finger-in-the-dike strategy to a “kitchen-sink” strategy. In other words, will the Fed be forced to eventually buy equities to keep systemic risks in check?

Disclosure: Author holds short positions in QQQQ, SPY

Comments

[Prudent Man...:]

Good information and facts.

Because of convexity, for those inclined to see great international inflation which is currently being covered up because all major countries are debasing their currency, the longer bond would be the one to expect to crash.

We are certainly not going to have Jeffersonian Democracy in the U.S. for at least the time the Prom King is president.

Jan 14 09:15 AM

[happysoul77777:]

Forget about the fundamentals. Technicals now rule!

People should short the SP500 until the government (the SEC) realizes that the market is structurally unsound. The allowance of naked short sales and the repeal of the uptick rule have sealed the fate of the stock market fourteen months ago.

Jan 14 12:31 PM

[xom-only:]

i don't think they will buy equities but they might get around to refinancing everyone's mortgage to below 3%, so we along with citi and others can get a fresh start on consuming - and with the baby boomers hunkering down and the rest of the consuming world lagging us i think 30 yr mort below 3% a necessity albeit in increments.

Jan 14 01:58 PM

[morph366:]

I find it baffling to contemplate the notion that one could find a suitable counterparty/insurer to pay out in the case of a default by the US government on its debts

Jan 16 04:28 PM