'Perceived Default'? / US Debt Rating On Review

Posted by urbandigs

Wed Jul 13th, 2011 06:34 PM

A: We might see some volatility in markets tomorrow as Moody's has placed the US on review for possible downgrade to its AAA credit rating. Given the past performance of these ratings agencies, or lack thereof I should say, this really isn't news. But it might make markets act a bit hairy. What you need to know is that bond markets will do what they want to do when a situation becomes unavoidable - just look at Greece, Ireland, and recently Italy & Spain. Government yields for 10YR Greek bonds are at 17% right now. Even though bailout after bailout continues to roll out of the ECB and IMF, the markets are taking matters into their own hands. The US will not default on their debt obligations like some EU countries might, but the damage could still come on a 'perceived default' by investors that results in our treasury markets taking matters into their own hands. That is the game of chicken that is going on right now between policy makers and bond markets.

Interesting times indeed. Bloomberg reports, "Moody's Places U.S. on Review for Downgrade As Debt Talks Stall":

Moody's Investors Service put the U.S. under review for a credit rating downgrade as talks to raise the government's $14.3 trillion debt limit stall, adding to concern that political gridlock will lead to a default.

The Aaa ratings of financial institutions directly linked to the U.S. government, including Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and the Federal Farm Credit Banks, were also put on review for cuts, Moody's said in a statement today.

The U.S., rated Aaa since 1917, was put on review for the first time since 1995 on concern the debt limit will not be raised in time to prevent a missed payment of interest or principal on outstanding bonds and notes even though the risk remains low, Moody's said. The rating would likely be reduced to the Aa range and there is no assurance that Moody's would return its top rating even if a default is quickly cured.

Treasury Secretary Timothy F. Geithner said he has taken steps to prevent a federal default until Aug. 2, using accounting measures that involve two retirement funds. The U.S. reached its borrowing limit on May 16.
chart.pngThis is part of a global endgame to the crisis that began in 2007. Its reaching sovereign debt markets and the fear of seeing "rates surge" is turning into reality for Greece, Ireland, Spain & Italy. Take a look at Greek 10YR Bond Yields on the chart to the right. Craziness.

Meanwhile gold, the ultimate barometer for measuring faith in global fiat currencies, soared to a record high today - if your still wondering if we are past the Great Credit Crisis of 2008-2009 just look to the price of gold for your answer. If all was fine and dandy in the world gold would not be trading just under $1,600 an ounce.

I am very confident that the US will never, ever default on our debt obligations because we can simply come to an agreement on our debt ceiling OR print our way out of the mess we put ourselves in (remember, we borrow in dollars and we print dollars). But that policy action has consequences and should buyers of our debt perceive a potential loss of confidence in US treasury bonds, the secular bull market in treasuries could reverse in a very big way. What is possible is a sharp reaction in our bond markets caused by perception shifts, much like what has happened in some EU bond markets. If that were to happen the fed's response would be to announce a tremendous US Bond Buying program, likely to the tune of trillions, in a desperate attempt to stabilize long term yields and keep rates low.

Up to now the fed's reflation policy has resulted in asset inflation for high risk assets as investors scramble to find yield. But what if the fed can't control everything? We know the fed wants and is keeping rates low by focusing on the short end of the curve. But ask yourself, can the fed really control the longer end of the curve if perceived risk for US debt rises? No way. That's the risk, not any actual default. What would life be like if US 10YR Treasury yields were 7% or 8%? Seems impossible with those same yields below 3% right now.

You see, when markets get jittery and credit blows out, money flocks to the safety of two asset classes:

1) US Treasuries, and
2) US Dollars

Equities and high yield security instruments are sold, dollars are raised and those exposed to massive leverage are caught swimming with their shorts down exacerbating the down trend. Gold is also attracting interest as a safe haven in the past few years and has proven to rise even when the US Dollar rises (late 2008 and early 2009) - going against the 'gold is a dollar hedge' play. So now what happens if uncertainty hits markets right as there is a mass exodus out of US Treasuries due to the nature of the uncertainty itself? Is that what causes gold to go parabolic? Is that end game? Will the fed be able to stabilize our bond markets if a worst case scenario hits?

This is your food for thought for today!