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04/20/2011

The Threat of Losing the AAA is Self-Fulfilling


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On Monday, April 18, Standard and Poor’s (S&P) put the US’s sovereign rating on negative outlook. The action was prompted by the continued deterioration of the US’s fiscal imbalances and the lack of urgency with which US political leaders have approached the country’s fiscal problems. By citing that Canada, the UK, France, and Germany all have better fiscal profiles including both better financial leverage ratios and stronger political discipline to manage their countries’ finances the rating agency has signaled that the US has lost its global financial pre-eminence. Such pre-eminence has allowed it to issue bonds at a premium to comparables and have a fiat money that has served as the world’s reserve currency. The US’s reign of global financial dominance has now officially ended.

The capital markets did not react as one might expect. On April 18, Treasury yields fell slightly, and the CDS rate on the US Treasury was up only a few basis points. Stock markets reacted negatively on Monday then inched back upward by the end of the trading day. Deciphering the reaction on the bond and stock markets, one might suggest that they either anticipated the S&P action (though the Treasury still trades as though it is risk free) or that they dismissed the action’s significance, not surprising given S&P’s recent track record. One hopes instead that the markets found a silver lining in the news, believing it will give Washington the scare it finally needs to enact a long-overdue austerity program. However, even meaningful austerity will not be enough, because the US’s fiscal health is far worse than what the official deficit and debt numbers imply.


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As bad as the current deficit numbers are, much of the US’s liabilities are off balance sheet. Even several good years of budget surpluses cannot stem the tide of new cash liabilities that will be coming due over the next few decades. The cash calls will be from public programs such as Social Security, Medicare and Medicaid, and Federal pensions all of which are underfunded. Then there are the federal guarantees, insurance, and or backstops of entities such as the PBGC, the FDIC, Ginnie Mae, the FHA, the Federal Home Loan Corp, and, for the time being, Fannie Mae and Freddy Mac, remaining TARP and TALF programs, the Federal Flood Insurance program, Federal Disaster relief, and Terrorism Risk Insurance Act. This list is not exhaustive, nor does it necessarily capture all new health care mandates. In addition to the liabilities assumed for these public and private programs, the Federal government has implicit guarantees or support for states, many of which have their own off-balance-sheet, underfunded liabilities. The US also has implicit guarantees for unthinkable events such as pandemics. The unfunded, off-balance-sheet liabilities and the contingent liabilities could make financial leverage challenges insurmountable over the next decade. Despite Washington’s best efforts, the chance of a material turnaround of the US’s debt problems is unlikely.

Having now officially lost its global financial hegemony, the US may have hit a slippery slope, increasingly relying on monetization of the debt, resulting in inflation and the decline of the dollar. The slippery slope is a compound issue of a structural reduction in the demand for treasuries, a structural rise in the need for government financing, and the crowding out of private investment. Thus, the threat of losing the AAA becomes self-fulfilling.

Prior to 2009, the Fed participated in the treasury market via its open market operations and bought paper on the secondary market. Then in March 2009, without much media fanfare, the Federal Reserve bought Treasury bonds at auction. These were direct purchases of new paper. The Fed could have bought bonds in the secondary market as it historically had done, freeing up investors’ cash to enable those investors to buy at auction or make purchases elsewhere. But instead, the Fed opted to create demand in the auction market in order to create an immediate impact on the market. Mechanically, there is little difference between the Fed’s buying at auction or in the secondary market. However, to the general public, the purchases stripped away the cloak of monetary policy and revealed a troubling sequence of events: the Federal government runs a deficit, the Treasury needs cash, and the Federal Reserve Bank prints money (doubling the size of the Federal Reserve Bank’s balance sheet from just under a trillion dollars to just over two trillion) then hands cash over to the Treasury.


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The Fed Chairman continues to underscore that the Fed’s actions were necessary monetary policy actions—that, given the seizure from the financial crisis, the Fed had to pump liquidity into the economy to prevent a depression, and auction purchases, among other tools, were the most direct method. Had the Fed not responded so immediately (buying at auction) and forcefully (over one trillion dollars), the economy would probably be in far worse shape. Unfortunately, the Fed’s classic monetary policy response signaled a different message to the capital markets: the Federal government’s spending spree is not financeable from traditional sources and the Federal Reserve Bank is willing to print money to pay the government’s bills. In other words, the Fed is no longer independent; inflation is a calculable risk the US is willing to take, consequently jeopardizing the dollar. This is not confidence building. The US Treasury is taking not just leverage, but huge liquidity risk, no different from Bear Stearns’, and therefore can suffer a crisis of confidence just as quickly.

With the loss of its AAA/Stable rating, the global demand for Treasuries should decline. Given the government’s growing fiscal needs, the supply of Treasuries should increase. Both of these forces will push yields higher. The Fed, in an effort to stimulate the economy, likely will attempt to push yields back down with Treasury purchases. In essence, the Fed and Treasury actions are redirecting investable funds to the Treasury in a textbook case of government crowding out, the consequences of which are generally low private sector growth and declining tax revenues. This is the making of a vicious circle of stagnant economic growth, a fiscal policy response that requires funding, followed by a monetary policy response that exacerbates the problem with more crowding out. As the Fed meets the supply of new Treasuries (deficits) with an increasing amount of monetization, insidious inflation pressure is established. If inflation pressure and worse—inflation expectations, are a natural consequence of a falloff in demand for US paper, buying Treasuries is a bad credit trade not worthy of the AAA, because the paper is collateralized with dollars for which value erodes over time. The threat of losing the AAA is thus self-fulfilling.

–Diane Coogan-Pushner, Queens College, City University of New York

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