The Corner

Default?

As we get closer to the U.S. debt ceiling, some useful background from Reuters’s Felix Salmon:

So although the government would have to live within its means, spending no more than it got in revenues, its revenues would still be far greater than the total amount of debt service. And with Jack Lew (or anybody else, really) as Treasury secretary, you can be sure that debt service payments would be priority number one. US government payroll — especially for the president and Congress — would probably be the first thing to get cut; the armed forces might be next, just to place maximum pressure on House Republicans. Then Medicare and Medicaid, maybe — the doctors and hospitals providing those services would just have to wait until the debt ceiling got raised before they received their checks. Failing to meet any of those obligations would not be considered a debt default, and would not trigger CDS [credit default swaps]…

So what’s going on in the odd corners of the financial markets which are suddenly receiving so much attention? The simple answer is that they’re trading markets. They don’t only go weird when the debt ceiling approaches: something similar happened back in January 2009. And here’s what I wrote back then:

“Anybody who bought protection at, say, 25bp is now sitting on a very nice profit if they close out their position. Maybe this is just a form of black swan insurance: buying US government CDS is a way of making money when everything else plunges in value. You’re not really insuring against an actual default, you’re just betting that if the world starts to implode, the price of your CDS is going to rise even higher.”

No one knows exactly how high CDS rates would go if we pierced the debt ceiling, but it’s a reasonable assumption that they would go higher than they are now, even if (as is almost certain) they never pay out a penny. The US CDS market is a speculative, greater-fool market: the trick is to buy at a low level, and then sell at a higher level. A bit like bitcoins, really. If you think that the debt ceiling is going to be hit, then it makes sense to buy CDS today, just because spreads are going up rather than down. The only trick then will be trying to time the perfect moment to sell.

And on T-bill yield “terror”:

[H]ere’s the reality: let’s say the yield on your $1,000 bill soars to a terrifying 0.446% from a relatively benign 0.184%. That means the price of your bill has plunged from $1,000.04 all the way to $999.88. You’ve lost a whole 16 cents — or 0.016%. If the price of your bond continues to dive at that rate every day, then after a couple of months you might start approaching a full 1% drop in paper wealth!

If you look at the actual price action in Treasury bills, then, it isn’t terrifying in the slightest; what’s more, it’s very difficult to separate signal from noise. There’s no indication whatsoever that it’s significantly raising the US government’s cost of borrowing, and there’s not even any real evidence that what we’re looking at here reflects credit risk being abruptly inserted into the interest-rate market.

For the fact is that Treasury bills trade far too close to par, far too predictably, for them to really trade at all. If you want to buy Treasury bills, you buy them at a Treasury auction, you hold them to maturity, and then — most likely — you roll them over into a new series of Treasury bills. On the other hand, if you want to trade day-to-day movements in short-term interest rates, you don’t go to the Treasury bill market at all: instead, you go to Chicago, and use the eurodollar futures market, or something like that.

The Treasury-bill market, then, is a bit like the market in US CDS: it’s a thin market which is being asked to support much more rhetorical weight than it can reasonably bear. In the real world, Treasury bills remain an absolutely safe market — and I fully expect them to continue to trade at (or extremely close to) par even if we hit the debt ceiling. The world will get much riskier, if that happens — and in a risky world, US government debt is still going to be the safest possible asset.

Whether we want to be in a situation where commentary like the above is necessary is an entirely different question.

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