Treasuries Should Rally If The Debt Ceiling Is Not Raised

by: Macro Investor

Let me start by making one thing clear: I am 100% sure the debt ceiling will be raised. While I do not want to get into the politics of the debt ceiling, anyone following the proclamation from the leading Republicans knows this. That said, I still think it will be interesting to think about how the Treasuries will behave in the event of an impasse on the debt ceiling.

Let's start with the conventional perspective. If the debt ceiling is not raised, the U.S. defaults. If the U.S. defaults, its credit rating goes to that of Greece, and there should be a run on the Treasuries. Yields should spike, value should fall, the Treasury shorts should make out like bandits. The dollar should collapse as well as there is a flight of money out of the U.S. A general Armageddon, in other words.

But does this conventional wisdom really hold water? I would like to present a completely different contrarian position, that if the debt ceiling is not raised, Treasuries will rally hard.

First, let's start with who owns the bulk of U.S. Treasuries, as these are the guys who will have to be selling (or lending shares to shorts to sell; I am assuming for the sake of the discussion that the U.S. government as well as all other foreign governments will move to stop naked shorting of Treasuries). These include the Social Security Administration, the Fed, state and local governments, other quasi-governmental agencies like the housing corporations, etc., foreign governments, and finally, the investor community. The total debt is around $16.4 trillion, of which about $4.8 trillion is held in inter-government accounts and is not marketable. The total marketable debt is $11.6 trillion, of which foreign governments (either directly or via their citizens) hold about $5.3 trillion. That leaves $6.3 trillion held by investors.

Let's first take the non-marketable debt out, as these are not going to be dumped. I believe that it is highly unlikely that the foreign governments will be dumping Treasuries, either. China and Japan are the two largest holders, accounting for about half this pie, and both are export-based economies. It is not in their best interest to have the U.S. dollar crash, thus strengthening their own currencies and ruining their own economies. Next comes the oil exporters, where the same story applies. As for the rest, most of these governments hold U.S. Treasuries as a way to gain confidence in their own currencies, as well as to trade in oil, which is dollar denominated. Unless we believe that oil will suddenly start trading in euros, it is very unlikely that these governments will start dumping their Treasuries.

This is very important. The U.S. is not Greece, it is not Spain, or Italy, or Iceland, or Ireland, or what have you. The U.S. dollar is the reserve currency in the world, which can change, but only over time, and not at the drop of a hat. So, the U.S. debt in play is only the $6.3 trillion held by investors.

Still, $6.3 trillion is a big number. What these securities are being used for? Enter Dodd-Frank.

Dodd-Frank aims to curb the appetites of risk takers and speculators. When speculators place their punts, Dodd-Frank requires them to post collateral -- good-quality collateral. Reports Businessweek:

To improve the safety of the financial system, the Dodd-Frank reform law requires that most derivative deals be executed on a clearinghouse that will require traders to post collateral and will provide a central place for regulators to keep an eye on risk in the market.

Bank of New York Mellon (NYSE:BK) estimates that investors will need as much as $4 trillion in good collateral to comply with the new regulations.

Now, $4 trillion is a big number. As you can see above, there's only about $6.3 trillion of investor-held Treasuries out there. While there are other forms of good quality collateral, like high grade corporates, Treasuries remain the bread and butter of this sector. Besides, in the event of Armageddon, the high grade corporates can become low grade in a matter of months as earnings collapse. The odds of Treasuries becoming junk bonds, however, is much lower. Even assuming half of the $4 trillion demand is met by the Treasuries, we can safely say that only about $4.3 trillion in Treasuries remain in play should there be a big downward move in U.S. government debt.

This is where things get tricky. Imagine you are someone who will need U.S. Treasuries no matter what. Now you know that the supply of Treasuries is drying up. What would you do? I posit that you will buy as much as you can lay your hands on. This puts a floor under the Treasuries.

Another very nice floor under Treasuries is the aging U.S. population. These folks are nearing retirement and need safety investments. I seriously doubt if they will start to sell their TIPS and Treasuries holdings should the U.S. default. Frankly, they may not even know what's going on with the debt ceiling, which is something that gets talked about a lot on Seeking Alpha, but is not really a Main Street topic. People are busy leading their lives and working and such.

At the same time, there is QEternity. The Feds are committed to buying about half a trillion dollars in Treasuries in 2013, so you have another floor there.

Finally, what will the major trading partners of the U.S., such as China and Japan, do? As mentioned above, they wouldn't want a dollar crash, so they will buy Treasuries. China hasn't bought much in recent years, so they have a lot of other currencies that they can easily trade out of. Japan wants to reflate, and what better way to reflate than to print a bunch of yen and buy U.S. Treasuries? This, frankly, may be the strongest floor under the Treasuries.

So, in summary, most of the U.S. Treasuries are not available for shorting, and there is a strong floor from multiple agencies. Given that, I believe that the future scarcity in Treasuries caused by a firm debt ceiling would actually pave the path for a nice rally in Treasuries should the debt ceiling remain in place and not be raised. This is counter-intuitive, and I will never get a chance to test my theory. But I hope it made for some stimulating reading.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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