Posted by Joseph Y. Calhoun, III

The Wall Street Journal carried a short editorial with this title last week concerning the price of various credit default swaps:

Along with giving Ben Bernanke another term, the Senate voted yesterday to boost the federal debt ceiling by another $2 trillion to a titanic $14.3 trillion. Yet as Democrats debate whether to use the headroom to launch a new trillion-dollar health care entitlement, the choice may not reside with the House (which must still vote on the debt ceiling) but with the bond market.

Trading in the credit-default swap market this week shows that investors now view a default by the U.S. Treasury as more likely than a default by the Coca-Cola Company. Until very recently, this scenario seemed about as likely as Coke winning a taste infringement suit against Coke Zero. Now the United States has taken its place next to Italy and Spain in a special club that no major country wants to join — countries whose debt is considered less safe than that of Blue Chip businesses.

Mr. Obama may not be deterred by the verdicts rendered by voters in Massachusetts, New Jersey and Virginia lately. But he won’t be able to ignore investors if they send Washington’s currently cheap borrowing costs soaring. That would surely be the result if markets become convinced that spending and inflation are destined to run out of control under the combo of Nancy Pelosi and Ben Bernanke. To be sure, we’re not there yet. But the recent financial crisis should have taught us that, when markets make up their mind that the story has changed, they can turn against you with blinding speed.

John Chapman (Adjunct Scholar at the American Enterprise Institute) sent me this comment:

…the threat of a collapse of the US bond market, which would happen as quickly as, say, Enron imploded or the market dropped in fall of 2008, is quite real, and another milestone on the way to it happening occurred this week.  It is hard to figure out how best to play this as an investor, except to say it’s better to be a debtor and in possession of hard assets in a moment of general collapse, rather than being wiped out as a creditor.  But of course there is a crosscurrent between debt and hard asset control, too, so it is a long discussion.  At the least if the US government were to default it would take the stock market with it so it would be best to own non-US and non-dollar denominated securities.   Gold would be a sure safe haven.
 
In any case this is extraordinary news.  I believe I am correct in stating that this is the first time since insurance markets for sovereign debt were developed that US Treasury debt insurance is more costly than the top rated private sector companies here.  An amazing “Rubicon” to have crossed, though the press will under-report it.  The road to hell is paved with good intentions, alas….. these politicians really meant well as they drove us over the cliff and into a new depression — I still fear we will learn what 15% “official” unemployment feels like. (F)or me personally it is still hard to get a mental grasp of the US government actually defaulting on its debt and what that would take — but via a law of recursive math it is of course guaranteed given the current trajectory.  Far before the government pro-actively refused to redeem its notes and bonds, what likely WOULD happen, and in our lifetimes is possible, is, one day the Chinese and Saudis and Japanese decide to stop holding our Treasuries.  They fear it is no longer a safe haven.  So as they dump holdings, the bond market collapses and interest rates sky-rocket.  Much like a run on a bank by depositors, all of a sudden even, say, the Canadians and US individuals get nervous and rush to sell US Government debt.  This causes the currency’s value to become worthless rather quickly, as in Weimar Germany.  The US government would then issue an edict of general repudiation and some sort of “new currency” reform, amidst the chaos of a society reduced to barter.  Not likely soon, but hardly unthinkable.  And in the meanwhile, higher inflation and interest rates will stall the “recovery” and ensure continued sluggishness, and drive capital investment away from the US.   This is why cutting taxes sharply and ending the spending insanity are imperative (both of which would strenthen the dollar and keep interest rates lower than otherwise), along with the short term hit certain banks will (finally) take in getting assets priced correctly.  It is also important to point out that with commodity (gold) money and a true free banking system, none of this would have or could happen.

My comment: The idea that China, Japan or the Saudis would dump Treasuries is one that has been around for some time. It is possible that it happens as John and others have envisioned; they lose faith in our ability to pay and stop viewing the US as a safe haven. I would point out though that they aren’t buying Treasuries as a safe haven; they are buying Treasuries for exchange rate management reasons. I would also point out that dumping Treasuries (and by inference, the US dollar) is not in any of these countries best interests. Even if there is a possibility that this happens, it isn’t the scenario that keeps me up at night. What worries me is the potential for internal conditions in one of these countries to deteriorate to the point where they become forced sellers of Treasuries and dollars.

What if the trigger for the global bond market rout isn’t that the US can’t finance its deficit but that some other country has financing problems? The prime candidate? I think the trigger could very well be Japan. Their government debt/GDP ratio is much higher than the US and they have rates even lower than ours. They’ve been able to fund all their bridges to nowhere by selling JGBs to Japanese individuals and institutions. The problem? Demographics. The savings rate in Japan has been falling for years and with the aging of their population will eventually turn negative. The Japanese saved over 10% of their disposable income in the early 90s but that has fallen to around 2% now. What will the government do when they can’t sell sufficient JGBs to the domestic market? I seriously doubt they can continue to fund their debt at 1.3% selling yen bonds to foreigners and even at the current low rates interest expense is roughly 1/3 of the budget. If rates just rise to the level of the US, interest expense is the budget. 

This is the situation that we should fear because if (when?) this happens the Japanese won’t have much choice about whether they want to sell Treasuries - they’ll have to sell them at whatever price they can get. To put it more simply, deflation would no longer be an issue in Japan.

And yes the effect on the US bond market and the US dollar would be the same. My only point is that while the US fiscal picture is ugly, it isn’t even close to the ugliest. There are lots of ways for the global bond market to blow up; don’t get caught up in one scenario. Things rarely happen the way the majority expects.

Update: John Chapman responds

 I just read your comment and I don’t think we disagree — I am agnostic as to the pressures that make the foreign sovereigns sellers of US debt.  It could happen as you say, in Japan, but it is equally possible that it happens by the Chinese signing a $200 billion 5-year infrastructrure development deal with the Koreans and Saudis and Russians…..and that scenario gets repeated around the world.  The world does not need us as much as they did 10 years ago.
 
Your thesis IS, however, the reason for the arrogance of the feds here in this town who are paid to worry about this, and it is exactly what Bernanke thinks, too.  People at the Treasury and the Fed just do not think that these foreign holders of our debt will make any significant moves on the sell side, as per the classic case of a debtor having a creditor by the short hairs.
 
I think that is a very dangerous game to play, based on a half truth.  And worse, it will mean the politicians in this country turn to tax increases as “an unavoidable” solution.

Tax increase or they crank up the printing press again. Either way the outcome isn’t good.