We continue to be astounded by the emergence of the pro-default meme within financial circles.
Now it’s someone at a major bank: BofA’s credit strategist Jeffrey Rosenberg, whose note from Friday is titled The Case For Default (via @dutch_book).
He explicitly rejects the doom camp, and thinks temporary default could be managed without significant market interruption.
We don’t find his argument to be all that convincing.
No one need create the catastrophic event otherwise feared from a temporary deferral of interest payments on Treasury debt arising out of a political conflict. Politicians on both sides of the debate could help to avoid that outcome by setting market expectations. With appropriate direction from Treasury or Congress, holders of Treasury debt could accrue their missed interest payments while continuing to accrue future interest payments. Though CDS contracts would likely trigger, with relatively limited erosion in bond prices there would be little disruption from the tiny amount of exchanges of cash flows. Treasury can continue to roll over maturing debt into new debt. Would US foreign creditors hold their collective breath under the expectation that the long term benefits of improving fiscal sustainability outweigh the temporary cash flow disruption? And from their
authoritarian perspective, would Chinese creditors to the US react stoically to a temporary disruption in their payments if they understand it as a necessary (and temporary) cost under the fractious US democratic system for securing the long term stable purchasing power of $1.1 trillion worth of US promise backed-debt? They might not. But they may face little other choice but to react with calm.
This raises so many questions. How are Congress and the Treasury supposed to give global markets “appropriate direction” about how this will work out? More importantly though, what is this supposed to accomplish? How does this temporary default get the US, with Washington DC so wildly divided, any closer to some long-term budget strategy? This is all incredibly confusing.
Then Rosenberg pivots. The US doesn’t actually face any debt risk. Just inflation risk.
Much has been said of the market consequences of failing to raise the debt ceiling and the related, though not necessarily linked issue of defaulting on the debt. However, the long term market response may be positive as well. The difference between long term and short term interest rates stands at historical highs. And while part of that reflects the cyclical conditions of easy monetary policy, another part reflects a risk premium reflecting the rising credit risk of holding US Treasury debt under current trends of budget deficits. Willingness and ability to pay timely interest and principal defines sovereign credit risk. As the US debt is denominated in its own currency, impairment of ability to pay implies
the Fed forgets how to run its printing press. Long term credit risk in holding US debt therefore reflects inflation risk – and the likelihood the government will eventually need to resort to higher levels of inflation to attempt to ease its debt burdens. Fortunately or not, such a solution will prove elusive as the average maturity of the debt – at less than 5 years – is too short for inflation to solve the
problem. Only by setting the fiscal policy on a sustainable path can this outcome be avoided. In place of financial market uncertainty, movement towards fiscal sustainability may ease some of the worry out of the long term interest rate market. That benefit might outweigh the near term costs of market uncertainty from a temporary delay in Treasury interest payments and a prioritization of payments required were the debt ceiling to be maintained as part of negotiating that sustainable fiscal policy path.
Again, we ask, how does this temporary default solve anything? How does it get us closer to the finish line of changing the course of the nation’s fiscal trajectory? It doesn’t.
Beyond that, Rosenberg seems basically alone in thinking the bond market is pricing in some significant debt-associated risk.
While he’s right that the spread between long and short-term debt is near historical spreads, this seems more due to the fact that the short end of the curve is abnormally low (thank you, QE), rather than anything happening at the long end.
Remember, 30-year yields remain really close to all-time lows.
Basically, longer-dated yields have moved with the market — up when stocks go up, and down when stocks go down, as they have for a long time.
The merits of the argument aside (and in this case, Rosenber’s argument is pretty weak), the real story here is the strength of the pro-default side of the debate, a stance that Treasury Secretary Geithner has called “Unthinkable.”