The Vanishing American Default

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 |  Includes: TLT
by: Joseph Trevisani

With the much-bruited US default looming, yields on Treasuries have fallen slightly. In the face of supposed catastrophe next week, investors are accepting lower yields today in the very instruments that may default on payments tomorrow. What could be the logic behind such financial insularity -- has the Treasury market moved to Mars?

Washington politicians have multifarious motives and are most familiar with the truth in public when it fits their political goals. Relying on their financial analysis is pointless. The US will not default on August 3 because someone or everyone in Washington says that it will. Let us instead examine the possible reasons that bond holders, the owners of US debt, are not worried.

One idea to note: there is nothing automatic in the bond market even if the Treasury misseS an interest payment. Investors are not required to sell their holdings; they choose to sell their portfolios. Even after a payment miss, a sell decision might be based on two considerations: Is the default permanent, and where else can I put my money?

A rating downgrade is a different story. It would force reactions in the credit markets, as certain institutions are required to hold debt instruments of a specific rating and a downgrade of US Treasuries could affect the external rating of other institutions via their portfolios of US debt. But the reaction would probably not be as violent or widespread as feared. But that is not our consideration here.

The first reason why the bond market is complacent is the easiest. The two sides in the limit debate will in the end agree to something and the debt limit will be raised. The entire debate has not been about the limit itself but about the budget deficit and the size and funding of the federal government. The debt limit is the catalyst for the debate but it is not the essence. Spending and taxes are patently and exclusively political topics. They are not incidental items or posturing by the players. Money decisions, spending and taxes, are central to the running of the government. In effect they are the government. They are precisely the types of disagreements that a political system, this or another, is designed to accommodate. The very public and non-stop coverage of the disagreements should not conceal the fact that this is the way politics works. It is a process that has always produced a solution in the past and will do so this time as well. The market insouciance is well-based in American political history.

The second possibility is that the supposed limit expires on August 2 without an increase and the government cannot borrow any more money to pay its bills. Two things will likely follow. First the Treasury will find the funds to keep the holders of notes, bills and bonds whole. The US will not miss an interest payment. Second, the outcry from the public and business and the entire world would be so loud and insistent that Congress would be forced to an agreement and again no payments or redemptions will have been missed.

A third possibility, though of a vanishingly small chance, is that the debt limit is not raised. Ever. Period. The government then has to find a permanent 40% reduction in its expenditures. In that case default is inevitable. So is world financial chaos.

The only possible conclusion from sub-3.0% rates on the 10-year Treasury is that scenarios one or two are possible and neither will prompt a selling run on Treasuries. The third scenario is not possible. It may occur that the idea of an American sovereign default is too awful for traders to contemplate, but I doubt that.

Risk analysis is all about risk, the probability of an event taking place. In the eyes of the Treasury market there is simply no chance that the US will default on its debt. This is not to be confused with the fact that a default is possible. It means that the credit markets do not judge a default as an event with any real probability of happening. In the eyes of the people most concerned, the Treasury market, the default talk in Washington, like all other discourse in that town, is purely political. Politicians and journalists, each for their own reasons, are confusing possibility with probability, but they are not risk analysts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.