I suppose it should not be surprising that there is a great deal of misinformation and misunderstanding about the debt limit and government default. A lot of people and especially folks in the media don’t understand these issues because they have never confronted them, and the warring parties seem to believe they have an incentive to get the media telling their story by whatever means necessary, even if that means spreading disinformation.
Some of this is confusion among non-financial people about what “default” actually means. An individual defaults when he or she fails to pay bills within a reasonable time after they come due. If the default is serious enough, a creditor can force the defaulting party into bankruptcy and attach assets.
This isn’t what it means to default as a sovereign country, however. A sovereign default is when a nation fails to pay interest or principal on its debt when due. And that’s all. If the U.S. fails to pay its soldiers, that is not default. It’s a bad move, perhaps, but it is not default. If the government doesn’t pay you, you can sue…but even if you win, there is no Chapter 7 or Chapter 11 bankruptcy for the U.S. government so you cannot attach assets. So this distinction is key: if the U.S. services the debt, there is no default. This is the case whether or not the debt limit increases or not.
It is much more surprising to read James Baker, who among other things has been Treasury Secretary, equating the debt limit increase with solvency. Mr. Baker was interviewed for Peggy Noonan’s column this week in the Wall Street Journal and said, speaking of the President, “He has to get the debt limit raised to avoid default.”
We can walk this through and show why there need not be a default in the case where the debt limit is not raised.
While the government at some point ceases to spend, since it doesn’t have Congressional authorization to do so, it still continues to collect revenue. The U.S. takes in a little less than $3 trillion per year in revenues, and if you think those taxes don’t need to be paid while the government is shut down I invite you to try. Against that revenue, interest payments on Treasury bonds are on the order of $300bln (I don’t have the exact figure). Principal repayments aren’t relevant for this calculation, because as bonds mature the Treasury can re-issue the same nominal amount of bonds. So all the Treasury needs to do in order to avoid default is to pay the interest. They probably also want to pay the $1.6 trillion in Social Security and Medicare payments, and maybe a fair amount of the $700bln in defense and homeland security spending although a lot of that is procurement. But there’s plenty more than is needed to avoid a default.
Incidentally, in theory the Treasury could take in more money by issuing Treasuries with above-market coupons. Perhaps there is a statute that requires the Treasury to always pay the minimum coupon possible, although I am not aware of it. But if there isn’t such a statute, then the Treasury could raise more money by doing the following: when a $10bln TBill issue comes due, the Treasury immediately re-issues a $10bln, 10-year, 10% bond at a price of around 165% of par. Voila, an extra $6.5bln for the coffers. What is limited by statute, as far as I know, is the face amount of bonds that may be issued, not the amount of money that can be taken in.
Now, the Treasury claims that it is unable to pay selected obligations. According to them, it is not operationally possible – the check run is either on, or it is off. All, or nothing. This represents either ridiculous incompetence, or an outright lie. Seriously? The Treasury has no way to cut a single check if it wants to? How about this: take a big stack of blanks and, instead of running them through the printer, fill them out by hand and have the Secretary sign ’em. Painful? Absolutely. But it is inconceivable that it isn’t possible to run only some checks. The Secretary should speak to his I.T. guys.
We should keep in mind that the Secretary is the President’s former Chief of Staff, and probably knows a lot more about the politics of appearing to be unable to pay than he does the actual capabilities of the machinery.
Does any of this make default impossible? Of course not. There is always the possibility that politics or petulance cause the President to simply refuse to order the Secretary to prioritize interest payments on the debt. It would most likely cause dramatic long-term costs for the government and precipitate a real crisis, and I wonder if it might even be impeachable (the 14th Amendment does not seem to me to give the President the power to raise the debt ceiling and pay anything he wants, but it certainly seems to give him the power to cut checks in order to defend the “validity of the public debt of the United States authorized by law, including debts incurred for payments of pensions.”) But there is no financial reason that failure to raise the debt ceiling should result in an actual default.
According to Bloomberg, investors are the most optimistic on stocks they have been in 3½ years. As is normal, investors mistake a sense of optimism about the economy for a sense of optimism on equities. As is normal, investors are reaching this peak of optimism as the stock market achieves its highest nominal level in five years, and among the highest valuation multiples in … hey!…about five years. What a coincidence! (Incidentally, while we calculate our long-term valuation metrics ourselves this page is a pretty good source for a quick-and-dirty view of valuations. I don’t have any relationship to the company and this is the only page on the site that I’ve used so I am not endorsing any other page!)
Now, while I am probably as optimistic on the economy as I have been in the past few years, I’m still less-optimistic than the crowd since I think the crowd hasn’t yet assimilated the fact that the little growth spurt at the end of Q4 owes quite a lot to the movement of dividends and incomes into Q4 from Q1, and thus the first quarter of this year will probably look rather poor.
In fact, while I am clearly negative long-term on the prospects for nominal Treasury bonds, that’s my investment view. My trading view is that at 1.84%, Treasury bond yields are probably going to go lower before they go higher. That’s partly because the present yields incorporate a lot of enthusiasm about growth – enthusiasm I think will be dashed once the January numbers begin to be reported in earnest. But the trading view is also because the Fed is buying virtually all of the net supply the Treasury is supplying to the market, with no sign that project is ending. I have no illusions that buying 10-year Treasuries at 1.84% and holding to maturity will be an awful investment. But if I was a short-term swing trader, I’d play for the next 20bps to be lower, not higher, in yield.
With respect to January data, incidentally, here is what we have so far (outside of Initial Claims, which as I have pointed out previously are all over the map at this time of year):
|Release for January||
|NAHB Housing Mkt Index||
|Philadelphia Fed Index||
|Richmond Fed Mfg Index||
For the most part, these are not just misses but big misses. I wonder how long it will take for investors to notice? Initial Claims on Thursday could get attention as the numbers start to converge on the actual condition of the underlying economy, but the first big January datum is the January 29th release of Consumer Confidence, which is currently expected to rise slightly from December. That is followed by ADP on January 30th (but any weakness there will likely be tempered by the advance release of Q4 GDP on the same day), the Chicago PMI on the 31st, and the ISM PMI and Unemployment on February 1st. Regardless of what happens over the next few days, I don’t want to be short bonds headed into that gauntlet next week.
I said the January data were big misses “for the most part,” because the NAHB miss wasn’t really a big miss. Housing is even strong enough now to resist downside surprises. As an aside, although it is a December number, the median price of existing home sales rose 10.89% year-on-year. Adjusted for the level of core inflation (so that we’re looking at the real rise in existing home prices), this is the fastest rise in history except for several months in 2005 – see the chart, (source Enduring Investments).
As for stocks, the fact that investors are as bullish as they have been in a third of a decade is sad but not terribly surprising (although this is a survey of Bloomberg users, which supposedly are much more astute since they have to come up with the 1700 clams per month for the service). On a related note, I was recently reading an article, called “I Saw The Movie,” in the January issue of Financial Advisor Magazine. In the article, the author compares the fear that some investors have of the stock market to the (irrational) fear of going into the water after watching Jaws. The author notes that “If your balance in 2011 resembled your balance in early 2008, you lost three years – but you didn’t lose any money, unless you sold out of panic…the vast majority of big losers were those who sold at the ebb of fall of ’08 to the spring of ’09 and parked their boats in the shallows of rock-bottom savings accounts.”
This, it occurs to me, is the real toll that the Fed’s QE has had on the investor class. It taught the wrong lesson. The lesson that has been taught is that you should hold on through all things, good and bad, and things will be okay. It is true that with hindsight, those who sold with the market finally at fair value (but no cheaper) in March of ’09 missed a rollicking rally all the way back to similar levels of overvaluation. But the real lesson should have been that most investors shouldn’t have been overweight in equities in 2008 or in 2007, based on market valuations. In the absence of manipulation of asset prices through the “portfolio balance channel” (see my discussion of this phenomenon in my recent article “A Relatively Good Deal Doesn’t Mean It’s A Good Deal”), those who sold in March of 2009 would have missed an average market return rather than the 21% per annum the market actually delivered since then. So the problem isn’t that they got out in 2009, but that they got in (or stayed in) in 2007 and 2008, and then got out in 2009. Investors who heeded the overvaluation of the market at, say, year-end 1998 and never got back in have earned a compounded return of 2.54% in T-Bills, 7.39% in TIPS, 5.64% in commodities, or 5.77% in the Lehman/Barclays Agg (nominal bonds) compared with 2.94% in stocks.
And that return is based on the pumped-up valuations that still exist in stocks today.
Investors, and their advisors for the most part, haven’t learned the right lessons yet, which is why patient investors are still having to wait to get back into equities even though the Federal Reserve is working very hard to force them back into the market via the portfolio balance channel.
The right lesson is this: investing for the long term is mostly about valuations, and very little about the economic cycle, the news cycle, or the lunar cycle. And two of those three we can’t predict, anyway. Yes, there is a tactical element of trading, but most investors should be (a) rebalancing on a regular basis, (b) paying attention to basic rudiments of asset valuation so as to adjust – mainly at the margin – their basic asset mix, and (c) turning off the television.