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The U.S. Debt Landscape Post-Aug. 2

7/19/2011 --

Professor Nejat Seyhun says market participants do not expect U.S. government to default.

ANN ARBOR, Mich.—The budget and debt ceiling negotiations between the White House and Democratic and Republican leaders of Congress have not been especially fruitful so far. Based on Treasury estimates, the U.S. government will run out of money sometime around Aug. 2 unless the $14.29 trillion debt ceiling is raised. According to many financial market commentators, the consequences of a U.S. default are nothing less than catastrophic. If a default occurs, the United States will not be able to pay principal plus interest on some maturing debt. In addition, it will not be able to fully meet its payroll obligations.

Yet, in spite of all the potential doomsday scenarios, we are within two weeks of Aug. 2, and the 10-year benchmark Treasury note has barely budged. It is actually yielding slightly less today (at about 2.91 percent) than a month ago (2.95 percent). Even 30-year Treasury bonds have hardly moved. The yield on 30-year Treasuries has only increased from 4.2 percent to 4.3 percent over the past month. What explains this curious phenomenon?

One hypothesis is that the markets are uninformed and inefficient, and the market participants do not realize the potential consequences of a default. Another possibility is that a default by the United States is not a serious issue since everyone knows that this is only a technical issue and the U.S. government will be good for its debt. Thus, even if a default occurs, it will not have much of an impact on the interest rates. A third possibility is that market participants do not put much weight into a default scenario.

Politicians like to bluff 'Armageddon' as a negotiating tactic, but they will not drag the United States into an actual default. Cooler heads will prevail, either one or both parties will blink and the debt ceiling will be raised. Which is it?

We can dismiss the first hypothesis easily. The U.S. Treasuries are among the biggest and the most liquid. The costs of buying and selling Treasuries are next to nil. Moreover, there is evidence that the market participants are in fact intensely focusing on the possibility of a default. Market data credit default swaps indicate that the volume, outstanding amount and the insurance premiums on the U.S. debt have all increased. The premium required to insure against a U.S default has, in fact, increased more than fivefold since May 2011, from about 10 basis points to more than 50 basis points. The insurance premium is still small, but the fivefold increase in premium easily puts to rest any notion that the market participants are uninformed or uninterested.

We also can dismiss the second hypothesis pretty easily. Even a technical default would have grave consequences for the pricing of U.S. debt. Also, the longer the default lasts, the more serious its consequences would grow. On Monday, Fitch Ratings announced that if the U.S. government defaulted, it would slash the credit rating of its defaulted debt securities to B+. Fitch said the B+ is the highest rating it can confer on defaulted securities even if investors can eventually expect to get paid all or most of what they're owed. As of Aug. 2, about $90 billion of U.S. debt could be pushed into default.

B+ is a junk rating. By law, U.S. commercial banks are not allowed to invest in junk category debt. Moreover, most central banks are not allowed to hold junk category debt. Hence, we can reasonably expect massive selling of the defaulted U.S. debt by the commercial banks if the U.S. government defaults. This massive selling will definitely result in higher interest rates. Other sovereigns with a B+ debt rating include Zambia and Greece. The Greek benchmark two-year notes are yielding more than 25 percent. While U.S interest rates will not approach Greek rates, they will increase for sure.

Based on the evidence above, the most likely explanation for the pricing of U.S debt is that market participants do not expect the U.S. government to default. Politicians like to play brinksmanship to score points with the public. And if history is any indication, come midnight of Aug. 1, we are likely to get an agreement on the debt ceiling.

One more thought experiment for the curious. What if the unthinkable occurred and the United States defaulted? How would you play this? This one is easy also. Short everything possible. Short the stocks, corporate bonds, Treasuries, and the U.S. dollar. While you are shorting everything, don't forget to buy insurance against lightning striking the Washington Monument, either. I suggest however that you sit back and enjoy the summer, instead. I think I have seen this movie before.

Nejat Seyhun is the Jerome B. & Eilene M. York Professor of Business Administration and a professor of finance.



For more information, contact:
Bernie DeGroat, (734) 647-1847, bernied@umich.edu