Whacky Bond Markets

With deficit hysteria now growing with each passing day the risk that our leadership will blink and do something really dumb like raise interest rates gets larger. You all know how stupid I think such a move would be, but, hey, this is the all-knowing bond market we are talking about. You know that place inhabited by ultra smart, uber brilliant investors who hone their computer analyses and are invariably right about absolutely everything.

Like mortgage backed securities.

I suppose I am not allowed to point out the fallibility of the gods of Wall Street.

They seem to have such short term memories.

So do all the commentators who pay attention to them.

Let’s be honest we need to sell bonds. That makes the folks who buy them pretty important right now. We need to keep them all happy. To an extent.

You see investing is a two way street. We need them to buy our bonds so we can spend like crazy and bail ourselves out of the economic mess created by the insanity of the big banks and other investment companies who failed to analyze risk properly back in the run up to the big credit bust of 2008.

And they need us. Where else are they going to park their cash? There is a limit to the places all that investment can go right now. Think about it: the private sector is simply not investing. It is hoarding cash. Part of that hoard finds its way into our bonds. I realize that most of the stash goes into Treasury bills, which most folks regard as cash rather than as investment. But for the longer term investor US bonds are a safe bet. After all the possibility of a US default on its debt is just absurd.

Or not.

Here’s the fun part:

The activity in those notorious Credit Default Swaps on sovereign debt – i.e. the debt of a country rather than a company – has picked up a goodly pace. And not just on the places you would expect: Russia, the Ukraine, and so on are fairly weak economies with a track record of playing fast and loose with the bond markets. No the real action is now in CDS’s on US and UK debt. Spreads have widened a bit recently indicating that someone, somewhere, is a little nervous that the US will default on its debt. So those people are buying insurance in the form of CDS contracts just to be safe. That way when the US implodes totally and refuses to pay back its debt these wise folks can collect their money anyway.

Very clever.

And where do they buy these insurance contracts? Who is it that will be left standing even after the US has crumbled into ruin?

The big banks.

Ummmm.

Would these be the very same banks that rely on the US for bail out cash?

Yes they would.

Let me ponder this for … oh … all of a second.

Someone pays the big banks to provide them insurance against a default by the very Treasury responsible for shoring up the same big banks.

No I know I can be dumb sometimes, but help me out here. If the US Treasury defaults on its debt, just how stable will those banks – or any others – be? More to the point will they be there the day after in order to pay up on the CDS contracts?

Didn’t think so.

This is just one more example of the whacky way in which analysts and commentators get their proverbials in a gigantic twist.

So obsessed are they, and much of the financial media, with US debt levels, that they have taken leave of their senses. They actually think that Goldman Sachs, for example, is more credit worthy than the US itself. That would the same US that bailed Goldman out last year.

Not happening.

But because the analysts and commentators are getting hysterical about debt they no longer think of simple things. They are fixated on that debt level and see the end of the world all about them. We read silly articles about the US going the way of Argentina. We read about the urgency of tightening the Federal deficit and raising rates even though that would precipitate a Depression. We read about the profligacy of the US government and about its enormous unfunded liabilities.

And some people read all that and rush out to buy CDS coverage against their US bond portfolio.

I have a bridge I would sorely like to sell these people.

They would probably buy it if they knew Goldman Sachs was selling it. But they’d never buy it from its actual owners, because the owners are a government. And governments are the problem to quote my favorite incompetent president.

Sorry to be so sarcastic. But really. These are the self same geniuses who nearly sank the world economy. They bought toxic assets with unfounded glee and abandon. They packaged and securitized their mothers for all I know. Their credibility is zero. And now they bitch about the debt levels we need to reach in order to straighten out the mess they made.

Ugh.

On a serious note. For those of you who want to track just how the grown ups feel about our fiscal condition – which means turning off cable television – keep an eye on the spread between US bonds and the inflation proofed version of the same. That spread gives us a good indicator of just how much risk there is perceived to be in US debt. Not much given the latest data. Or you can take a peek at the US bond rates themselves: not very high at all. Or, for the truly daring, take a look to see if Goldman’s debt costs more then the US treasury debt does. Which is thought of as the riskier?

Get my drift?

Here’s the thing: yes our debt levels are shooting up. Hello: we have a crisis to deal with! Much of the deficit creating that debt stems from a drop off in revenues: people who are unemployed tend not to pay much income tax. Profits tend to be weaker in recession so businesses pay less tax too. Duh! Top that off with the need to bail out the banks and kick the economy into gear and we end up with an awful debt level. But it isn’t permanent. The deficit starts to drop off the minute the economy grows. So the ratio of debt to GDP peaks and then falls as soon as we get going again. GDP growth itself will lessen the ratio as long as we don’t keep our foot on the accelerator after the recovery is well established. And no one I know is saying we should. On the contrary I think there is too much premature talk of tightening. That moment is still someway off. We all want fiscal conservatism down the road. That means taking a good hard look at the budget and cutting some stuff out. It also means raising taxes at some point. Sorry folks nothing’s free.

If there’s one thing that the years of illusion should have taught us it is that the Federal budget should be balanced now and again, especially in years of good GDP growth.

Yes Messrs Reagan, Bush, and Cheney: deficits do matter. They always did.

Meanwhile let the bond market have its whacky moments. At some point as we pay down debt we will start to hear the lament of the late 1990’s: we need more debt! After all where are the investors going to get a safe return?

CDS coverage on US debt.

Please!