Kick the Can
Many people have recently (and correctly I believe) compared the government’s current actions with regard to fiscal policy to playing a game of kick the can where we push all of our problems down the road, make some very optimistic assumptions and hope it all works out in the end.
When I think of this it reminds me of the first (and only) time I ever played kick the can. I was in the fourth grade and the teachers brought out a big Folgers coffee can and explained the game to us. Being in the fourth grade we thought this was wonderful…we get to run around and kick something. What I remember most is how the game ended. It ended with Felicia Martin running toward the can with outstretched arms and a big smile when someone else booted the can as hard as they could…right into her face. Felicia (representing the average American taxpayer) went along with the kick-the-can game only to leave the field bleeding and crying. The rest of us stood looking at each other in stunned silence until one of the teachers announced that the game was over. She took the can and we never played it again.
I can’t help but look at my experience in the fourth grade as a metaphor for the current game we’re playing. Will the government keep kicking the can down the road until the tax payers are bleeding and crying and sitting in the nurse’s office? Will they play ‘til the point where someone forcibly takes the can (i.e. foreign central banks quit funding our current account deficit at very low Treasury yield levels) and announces that the game is over? I don’t have the answer but it sure feels a lot like the fourth-grade playground right now…we’ve got just the right mix of energy and lack of common sense to get someone hurt.
Downgrade?
We’ve previously covered our thoughts on the probability of a default on US Debt. In short, we don’t see it as something to worry about. The market doesn’t see it as something to worry about, and if you’d like the more full blown commentary just let me know and I’ll make sure you get some of the prior commentary on the issue.
Now let’s turn our attention to a downgrade and what that might mean.
What does a downgrade mean?
A downgrade indicates deterioration in an issuer’s ability to repay its obligations. It doesn’t necessarily mean that they can’t repay them…it just means that the financial condition of the issuer has deteriorated to some degree. Essentially, it means that the debt of this issuer is more risky today than it was before the downgrade.
Going back to Finance 101 we need to answer the question “how does the market compensate me for taking more risk?” The answer is that the issue must provide increased returns for increased risk.
For example, how much money would it take to get you into the ring with Mike Tyson? I’m guessing it will take a higher amount than to get you in the ring with…say…Tim Geithner. Clearly there is more risk involved with fighting the former heavy weight champ and ex-con Mike Tyson than fighting welterweight Treasury Secretary Tim Geithner…therefore you need more money to compel you to get in the ring. This is a basic view of the risk/reward structure of a downgrade. Your AAA fight is against Geithner…if your fight schedule gets downgraded to BBB then you have to fight Tyson…and you’ll need more return to take the risks that come with that fight.
Despite the massive government intervention of the past few years this next law of finance might be one of the few that they’ve not managed to turn on its head…bond yields have an inverse relationship to bond prices. If the price goes up, the yield goes down and vice versa.
So if today I wake up to find that my bonds have been downgraded (risk has gone up)…the prices of the bonds I own will drop to reflect that new level of risk. When the price drops the yield rises until it hits a level that entices new buyers into the market. This is the natural effect of a downgrade….falling prices.
Is that it?
In the case of a downgrade on a normal corporate bond, the effect of a minor downgrade will generally be limited to the price adjusting in the market to reflect the new information. Everyone then gets on with their business.
US Treasury debt however is not normal corporate debt. The US Treasury market is the world’s safe haven…it’s where people flee when there is a storm in the financial markets. The US Treasury market serves as the very benchmark for almost all other risky assets. The US Treasury curve serves as the “risk free rate” in countless financial valuation models. A downgrade of this debt would certainly cause ripples to run through every other area that prices off of this curve. Will the ripple become a tsunami? Nobody knows. It is certainly a very scary proposition to consider…but we need to consider both the theory of asset pricing as well as the reality of asset pricing.
In reality we are just a few short weeks away from the deadline that decides if we default, get downgraded, or fix things…and the market shows very few signs of concern. How could this be?
How could we be looking straight down the barrel of a default or downgrade of the world’s most reliable debt market…and still have huge demand for the paper?
In the theoretical world of asset pricing models we would expect that the default/downgrade news in the markets would be causing Treasury bond prices to fall as investors moved to protect their assets. In reality we continue to see robust demand for US Treasury debt. What should we make of this?
The market doesn’t appear to be pricing in any chance of default, and very little chance of a downgrade. It’s easy to see why nobody is concerned about a default…but why isn’t there concern about a downgrade?
Shouldn’t we be selling off ahead of a downgrade?
It would appear that the market’s view is that even if we get downgraded to AA…we’ll still be the biggest and best market around. It’s good to be AA+ in a world of BBB markets. Relative to the rest of the world…and despite all of our shortcomings…we’re still rock-stars by comparison. Market participants recognize this and they still view our markets as a safe haven.
Can’t investors just go somewhere else?
Whether they are rated AAA or AA+, our debt markets are deep, liquid, and safe. The size of the US Government debt is roughly $14 Trillion. The next largest AAA rated sovereign behind the US is the UK. The total available government debt in that market is $8.9 Trillion. Behind the UK are Germany and France with roughly $4.6 Trillion apiece in public debt. After that the supply of AAA debt falls off sharply to the point where the markets get so small that Bill Gates or Warren Buffet could single-handedly buy the entire supply of debt of some of these issuers.
While there may be poorly fitting substitutes available for those searching for high quality sovereign debt, there are no perfect replacements for our debt markets. Like Richard Gere’s famous line in “An Officer and a Gentleman” investors may end up crying “I’ve got nowhere else to go!”
If you have any questions or if there is anything I can be doing for you just let me know.
Steve Scaramastro, SVP
800-311-0707
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