Can A Sovereign Debt Crisis Happen Here? A Case Study Of The 1995 Debt Ceiling-Precipitated Government Shutdown
Lately there has been a lot of chatter among the supposedly smarter-than-mainstream media that even should the debt ceiling not be raised, it would not mean the bankruptcy of America as interest payments would still be satisfied. While that technicality is absolutely true, it is even more absolutely irrelevant. What propagators of such theories forget is that lately there are just two exponential curve trendlines that are worth noting: that of the cumulative debt issuance, and of the US cumulative deficit (see chart below). Each month, the US issues around $50 billion more debt than is needed to just fund the deficit. This is debt that is on top of the debt that is needed to plug the different between revenues and expenditures. As Zero Hedge has pointed out repeatedly before, that ratio is already roughly 1 to 2, meaning for every dollar in revenue the US government issues more than one dollar of debt just to fund the deficit. And then some. As the chart below shows, in December alone the government issued $84.4 billion on top of the budget funding shortfall ($80 billion deficit and $164.4 billion in debt issuance)! So yes, while the Treasury can fund interest expense at record low interest levels, that is completely irrelevant. Unable to fund incremental expenses to the tune of hundreds of billions per month, the US government will shut down (a point when nobody will accept US government IOUs, not Social Security which passed the point of being self sustaining last year, and certainly not Medicare and Medicaid, and most certainly not private sector Defense Vendors) just like it did in 1995. Below, we present the key charts and the full report from a must read SocGen report on the sovereign debt crisis, titled Can It Happen Here? We urge all those who pretend to have an educated opinion on the US funding crisis to read this report before they open their mouths in public and once again validate their critics.
First, below is our chart showing the monthly and cumulative differential between debt issuance and fiscal deficit (starting in October 2006). In December, the cumulative divergence between the two reached an all time high of $1,819 billion.
And next, courtesy of Aneta Markowska and her economic team at Soc Gen, here are the charts (and some narrative) that everyone should be familiar with ahead of the March moot debates on raising the debt ceiling.
First, the chart below needs no introduction.
Instead of spouting essayistic platitudes on just how swell the world would react to a US debt ceiling breach, perhaps those so inclined to come off as edumacated on the topic could actually analyze what happened the last time the government shut down during a debt ceiling crisis. Luckily, SocGen has done so for everyone's benefit:
It is difficult to disentangle the full effect of the 1995-96 debt-ceiling crisis on bond yields since Fed expectations were also changing rapidly during that time. If there is any conclusion to be made, it is the market generally shrugged off the government shutdowns and instead focused on macro developments.
The government reached the debt ceiling in November, and Treasuries generally rallied over the next three months even as the situation in Washington continued to deteriorate. That said, the Fed was also easing monetary policy during this period, having lowered rates by 50bp to 5.25% between December 1995 and January 1996. Nonetheless, reviewing press reports from this period suggests that the market seemed to ignore the debate over the debt ceiling in the early stages, having assumed that politicians would never allow the US to go into default and that a resolution would be brought about quickly. The biggest move occurred in the final days of 1995 when the market was generally optimistic that a resolution would be achieved.
At the start of the New Year, the market realized that negotiations were falling apart with Treasury Secretary Rubin warning sending the 10-year yield 8bp higher. Around mid-February markets began to react negatively to any news related to the budget stand-off; that is until late March when the ceiling was lifted. Treasury yields increased about 80bps in less than a month during this period. However, Fed policy may have been a bigger factor behind this move as the economy started to improve and the market began pricing out any additional rate cuts. Rising equity prices also added to the upward pressure on bond yields.
The lessons that could be learned as we look to a potential stand-off this year is that bond markets generally cared less about developments in Washington and placed more emphasis on monetary policy and the macro environment. There was also a general sentiment that no politician really wants to drive the US into technical default. Treasury investors may also view the debt ceiling showdown in a positive light as it pushes the debate in the direction of fiscal reform.
Here is the brief summary (much more in the attached report) on whether a sovereign credit crisis can happen here:
Over the past year, Europe has been engulfed in a sovereign debt crisis which has led to the bailout of Greece and Ireland. The US fiscal situation has garnered a few headlines and has piqued some interest, but it has gathered no momentum. The main difference between the situation in Europe and the US is that the former is a near-term risk while the latter is a longer-term one. Although the US problem is in the distance, event risk is increasing and timelines could be compressed. Most notably, with Republicans taking over the House in 2011, there is an increased threat of a stand-off with respect to the raising of the debt ceiling, which could result in a government shutdown, similar to what happened in 1995.
US Treasuries remain a safe-haven asset despite growing fiscal concerns. US sovereign CDS spreads are among the lowest in the G10, and well below the likes of Ireland and Greece. US CDS spreads over the past year have reacted very little to the turmoil occurring in Europe, with US spreads cooling off from highs of around 60bp early in 2010 to about 40bp by the end of the year. In contrast, G10 Europe has seen spreads move higher.
The near-term risk of a negative credit event for the US is relatively low, but that is not to say that it may not happen. Current budget projections suggest that the US could face a high risk of a ratings downgrade in a few years, unless action is taken to reform government finances. This is a common feature among most mature economies. The US, like the weaker European countries, has the added risk of heavy reliance on foreigners to fund public sector deficits. Of course, the US benefits from a reserve currency and currency pegs which maintain a steady bid for US assets, but the risk cannot be ruled out entirely. A significant decline in buying appetite could put the US on the spot much quicker than anticipated, as rising bond yields could bring the AAA rating Armageddon closer. In some ways, this could be a good thing as it should force policymakers to drop their bipartisan gloves in order to get things done.
All that said, the future trajectory of the US debt is unsustainable.
Yet above all, the next three charts are by far the most important in that they confirm three things we have been highlighting for a long time: i) US gross issuance will surge in the next several years; ii) so far the Fed is acquiring all the gross issuance by the Fed; this will end in June, opening up a massive hole that can not be filled by now traditional waning buying interest; iii) there has been a foreign strike for US treasury purchases which appears to be unending (look for this week's TIC data to confirm this decline in foreign interest in US Treasurys); iv) the propaganda's attempt to get retail out of bonds and into stocks will backfire, as much more demand for bonds is needed once the Fed departs the monetization scene. In other words, should ICI confirm a series of taxable debt outflows, it merely guarantees that QE 3 will be next up on the agenda as there will be no natural buyer of USTs left. However, for the Fed to get a carteblanche to monetize beyond the current QE sunset, there will have to be a sudden and dramatic capital markets shock as per the speech of Dallas Fed's Fisher last week. We expect a major orchestrated market crash in May or June to provide the Fed with the cover to continue monetizing the US deficit (i.e., treasury issuance). Either that or a sudden and dramatic deterioration in the economy. Look for Jan Hatzius to first of all Wall Street economists to flip his opinion from positive to negative as a first telegraphed sign that QE 3 will be up on the docket.
Below is SocGen's take on the "Achilles heel of the US fiscal situation" - external financing.
What would cause large shocks to the forward interest rate curve? One possibility is that foreign investors may reduce their appetite for Treasuries. Indeed, the heavy reliance on foreign funding is one of the key vulnerabilities facing the US government. This is also the main distinction between the US and Japan, and one that puts the US more in a European camp. Of course, the US has the advantage of a reserve currency and FX pegs are also a mitigating factor as they imply that foreign central banks have no choice but to continue buying US assets. These factors buy time, but they do not eliminate the risk altogether and a buyers’ strike is a risk that cannot be ignored. At the moment, bond investors have given the US government a benefit of doubt, but failure to address long-term fiscal challenges could ultimately trigger a loss of confidence and an outflow of capital from the Treasury market.
Currently, foreign investors hold 47% of Treasury debt outstanding, or about $4.2tn. Over the past four quarters foreigners have bought about 45% of new issuance, so their share remains constant for now. Households were big buyers in 2009-2010, but have reduced their purchases recently as the savings rate eased off its peak and as risk appetite has improved. Eventually, households and banks will have to buy even more, but for now there has been no deviation from the trends that prevailed in the past 10 years. Reliance on foreigners remains as high as ever.
Importantly, the risk does not lie with foreign central banks which are locked into Treasury buying by their exchange rate policies. The risk lies with private investors who have been significant buyers over the past year. Ironically, the US government has benefited from the European crisis which triggered a strong safe-haven bid in the Treasury market. By the same logic, a resolution of European sovereign problems could bring sovereign concerns into the US as capital outflows push Treasury yields higher. This is not a near-term concern, but one that we may have to consider at some point.
Of course, the Fed is the Treasury buyer of last resort, but the near-term outlook for the Fed could also prove problematic for Treasuries. The Fed has been soaking up most of the new issuance by the Treasury and private investors may demand a higher yield concession once the Fed exits its program in mid 2011.
Full must read presentation: