By Daniel Gross
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.
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