Freaked Out about the Debt Ceiling? Buy Bonds
June 11th, 2011
The U.S. is apparently hurtling toward a sovereign debt crisis. The debt limit is fast approaching, with no visible progress. Some Republicans have talked openly about the prospects of a brief default on U.S. government bonds. The ratings agencies, always the last to know about changes in financial conditions, are warning of a possible downgrade of America's debt rating. Washington has shown an unwillingness to compromise over anything in the past few years, except for measures that make the fiscal situation worse. And yet in the face of this, investors continue to pile into the market, pushing bond yields down. It's as if people reacted to warnings of a runaway train by going out and standing on the train tracks.
The thought that the rising prospect of a debt-limit debacle could cause government bonds to rally is counterintuitive. But, as Henry Blodget and I discuss in the accompanying video, it makes a certain amount of sense.
Lets unpack this a little.
Rule #1 of the past few years has been this. When bad things happen in the global economy — a tsunami in Japan, crisis in the Middle East, meltdown in Greece, fears of a slowdown in China — investors around the world react by selling riskier assets and flocking to the safest and most liquid asset around: U.S. government bonds. It's just the way the world's financial mind works.
This reflexive action still dominates behavior even though the next crisis could be in the safe haven of government bonds. And so even as it hurtles toward the deadline without resolution, as the tide of brinksmanship rises like the Missouri River, don't expect people to dump Treasuries and interest rates to spike.
And they're right not to unshackle themselves from government bonds. The U.S. is not going to default on its debt. Period. End of story. It will pay the interest on its bonds, and repay the principal of those that come due.
Consider the difference in mentality and behavior between private borrowers and public borrowers. As seen in the mortgage crisis and at times in the corporate world, private borrowers don't have any compunction about walking away from their biggest debts -- mortgages, bank loans or bonds. In many instances, debt payments came last. Lots of people who walked away from mortgages continued to pay their cable bill, cell phone and car payments, and to eat. At the other end of the spectrum, private equity billionaires chose not to scrounge up the cash to stay current on bank or bond debt when they realized they couldn't salvage the underlying company. They continued to pay themselves management fees, and buy homes and jets even as they shirked debt payments. The public sector takes the opposite approach. States and cities generally put bondholders first in line ahead of other priorities. Governments have all sorts of ways to conserve cash that don't involve missing bond payments. When California ran into cash flow problems in 2009, it didn't miss bond payments. It issued IOUs to vendors and furloughed employees. On a larger scale, that's what states and cities are doing.

They're slashing funding for higher education, laying off teachers, turning out streetlights, reducing pension contributions, cutting road investments — everything but missing bond payments. That's why municipal and state defaults are so rare, and why analyst Meredith Whitney's call for scores of municipal bond defaults is way off base. Yes, there will be some. But government reliance on debt to fund of operations and investments is so great that they'd rather alienate workers and citizens and taxpayers than anger the bond market.
The same holds true for the federal government. The U.S. is collecting plenty of revenues, more than enough to make its interest payments. So far this fiscal year it has collected $1.3 trillion in revenues and paid $244 billion in interest on federal securities. If it isn't allowed to issue new debt, there are all sorts of things the government can do to ensure it has the necessary resources to stay current on bond payments. Many of them would be painful and unpopular — cutting benefits and food stamps, delaying payment terms on contracts, refraining from placing big new orders. Of course, all these moves would be contractionary — they'd help slow economic growth.
And that's the reason the failure of the debt ceiling would actually be good for bonds and bad for stocks. The U.S. government occupies a pretty large footprint in the economy. It employs 2.85 million people directly. Next, think of all the businesses, many of them publicly held, that rely on the government for a big chunk of their business. For-profit education companies, defense contractors, the entire health care industry, Wal-Mart and other retailers that cater to people who depend on federal benefits to help pay their grocery bills. Every large consulting firm, every large tech firm (from Microsoft to IBM) has a large unit that provides services and products to the federal government.
Should the U.S. bump up against the debt limit without resolution, it's possible the Pentagon would delay indefinitely the signing of new contracts for fighter jets. Or agencies would cancel or slowdown payment on IT projects. Or Congressmen and their staffers would see their wages reduced. Or fewer people would get food stamps. The cumulative impact would be less demand, less economic activity, more uncertainty. Bad for stocks, good for bonds.
The stocks hurt the most would be those whose business is disproportionately in the U.S., and those whose U.S. business relies disproportionately on direct or indirect government funding.
Yes, the possibility remains that prolonged turmoil in the bond markets could ultimately lead to higher rates. It's possible that the debt limit High Noon could finally bring the bond vigilantes out from hiding. But consider what's happened in the past few years. Amid a huge expansion of the Fed's balance sheet, a sharp rise in government spending, trillion-dollar-plus deficits, and epic levels of political dysfunction, government bonds have rallied -- and rallied again. This five-year chart of the 10-year U.S. government bond perfectly illustrates the point. If all that couldn't rouse the bond vigilantes from their slumber, I'm not sure what will.

Economic Update: 5/14/11

Economic Update: 5/14/11

Stocks slide after European officials say bailouts will be larger than originally forecast

May 14, 2011-NEW YORK (AP) -- Since when does the stock market take its cues from the market for silver, oil and pork bellies? When it's really the dollar that's driving the action.

The stock market rally, which began in August, relied on stronger earnings, rising commodity prices and a weak dollar, said Andrew Wilkinson, senior market analyst at Interactive Brokers. But prices for commodities have dropped by 10 percent this month, and swung wildly over the past week. Oil, for example, was nearly $114 a barrel at the end of April. On Tuesday oil settled at $104, fell, rose and fell again, to close at $99.65 on Friday.

Falling commodity prices are widely blamed for driving down stocks. The Standard & Poor's 500 index has lost 1.9 percent so far in May. Other indexes are down more than 1.5 percent for the month.

It's not simply a case of investors selling because they believe declining oil prices are a sign that the economy is losing strength. Rather, since commodities are mainly traded in dollars, it's the dollar's recent rise that is largely responsible for pushing down commodity prices. If the dollar gains strength against other currencies, it takes fewer dollars to buy the same barrel of oil.

"Suddenly, the dollar is no longer the whipping boy," Wilkinson said. "And if the dollar is no longer the whipping boy, you can no longer count on a commodity-driven rebound to push up the stock market."

Worries over Europe pushed the dollar up nearly 1 percent on Friday and erased the week's gains in the stock market.

The Dow Jones industrial average lost 100.17 points, or 0.8 percent, to close at 12,595.75. The S&P 500 fell 10.88, or 0.8 percent, to 1,337.77. The Nasdaq lost 34.57, or 1.2 percent, to 2,828.47. The slide turned the Dow and S&P lower for the week.

Financial stocks fared the worst in the past week, followed by material and energy companies. Both Bank of America Corp. and JPMorgan Chase & Co. dropped 2 percent on Friday.

Companies in the energy sector fell the most in May. Exxon Mobil Corp. lost 8 percent so far this month.

The Dow fell 0.3 percent over the week and 1.7 percent for the month. The Nasdaq was flat for the week and is down 1.6 percent for the month.

The Russell 2000, an index of small companies, ended the week up nearly 0.3 percent, but is down the most so far this month, declining 3.42 percent.

In addition to the dollar's rising value, several other forces have led to the recent rout in commodity prices. A requirement that traders back their bets on silver with more cash spurred a sell-off in metals, which some traders say cascaded into other markets. Reports over the past week showing weaker demand and rising supplies for both crude oil and gas have pushed down energy prices. U.S. oil inventories have climbed to their highest level since May 2009.

Meanwhile, betting on a weak dollar has been a popular move. For much of the last year, traders bought commodities and sold dollars.

The dollar's sudden strength has caused them to reverse those bets. "That's been the big trade," said Dan Greenhaus, chief economic strategist at Miller Tabak. "And it's getting undone."

The downside: eventually a stronger dollar makes U.S. products more expensive to foreign buyers. Exports decline. Companies that sell everything from sneakers to aircraft feel their profits pinched.

Stocks in countries that use the euro fell after the European Union warned that the debt loads of Greece, Ireland and Portugal will be larger than originally thought. Officials said that Greece needs to cut spending further, which led to concerns that the assistance the country has already received won't be enough. The Euro Stoxx 50, an index of large companies in countries that use the euro, fell 0.8 percent.

Fears of a deepening financial crisis overshadowed reports that found that consumers are feeling more confident in the U.S. economy and that inflation remains in check. Consumer prices rose 0.4 percent in April, the Labor Department said. That was in line with economist's expectations.

Most of the increases came in volatile food and energy prices. Stripping those out, prices rose 0.2 percent and stayed below the rate of inflation that the Federal Reserve considers normal.

"Inflation doesn't look like the risk that everyone feared," said Doug Cote, the chief market strategist at ING Investment Management.

The prices that consumers pay have risen 3.2 percent over the last 12 months, the biggest 12-month gain since October 2008. Companies like Kimberly-Clark Corp. and Colgate-Palmolive Co. that sell households products have raised prices because of higher commodity costs that have cut into their profit margins. Costs for raw materials like oil, coffee, and cattle have risen more than 10 percent this year.

More than two stocks fell for every one that rose on the New York Stock Exchange. Trading volume was 3.5 billion shares.