The markets seem to have assumed away the busting of the ‘debt ceiling’. As Markit notes (here), credit default spreads have stepped out, but are still well below their highs for the year.
I’m beginning to suspect that the current calm may qualify as complacency with the benefit of hindsight – that the debt ceiling negotiations have the capacity to become the catalyst for a de-rating of US government debt. Let me explain by threading together commentary from some investment luminaries.
First, we have this interview with Bill Gross (here). He starts the conversation with a warning that the debt ceiling needs to be addressed and soon – the ‘ability to make good your debt’ is important for a reserve currency. He then clarifies that he is not short Treasuries but longer-dated US interest rates – it is not a view about US government default but about interest rates that have been kept artificially low. And finally, in saying that Greece is insolvent, he makes the point that “a country needs to grow at rates above its interest bill – either nominally or in real terms – in order to…stop debt levels increasing as a percentage of income”.
Notice the two bookends of his argument?
Second, we have Russell Napier (here). He is forecasting the Great Reset – where longer term US interest rates will be forced higher. He suggests that rising real interest rates in the emerging markets may well be the catalyst for one last deflationary thrust in the developed world. It’s an argument that says emerging market capital will flow home rather than be recycled into US government debt.
And finally, we have Jim Rogers (here), who in his inimitable way, expresses the same sentiment with regards to Treasuries – “I want to sell them short”. But it was really what he said next that struck me – “Normally throughout history, when a country starts going down, either its currency or bonds, it’s usually the internal players who sell first”.
So when you have the largest bond fund in the US not owning Treasuries. And you have Google issuing $3bn in US$ denominated bonds so that it doesn’t have to repatriate any of its $37bn in cash sitting in foreign currencies. You have to ask the question are the ‘internal players’ selling? And then, following Russell Napier’s lead, what will it take for the foreign holders of US debt to follow?
Conclusion – I’ve been expecting the US$ to rally through the end of QE2 – most particularly given the overwhelming shorts that have been established presumably with the view that QE3 is a near certainty. A short squeeze rationalised on slower growth expectations with a commensurate return of risk aversion is still the most probable near term outcome for mine.
But reflecting on the risk around the ‘debt ceiling’ negotiations leading up to August, I’m now coming around to idea that the more uncertainty that surrounds the outcome, the less favourable it is for the US dollar and Treasuries. Perhaps the best risk/reward trade here is one that says ‘short US Treasuries’. Certainly, it fits with the technicals (from Kevin’s Market Blog):
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