Nightmare is a sweet dream for bonds
James Saft is a Reuters columnist. The opinions expressed are his own.
HUNTSVILLE, Ala. – To understand why the U.S. lost its AAA rating yet its bonds rallied you need only consider that recent events are bad for growth but good for creditors.
The downgrade by Standard & Poor’s, the first ever for the U.S., helped to cement the view that the U.S. will be rescinding various guarantees and pledges it has made to those to whom it does not owe money.
The downgrade doesn’t make the U.S. a worse credit; it recognizes, too late and by not enough, that the U.S. has a mismatch between its obligations and its will to meet them. Congress has demonstrated that not only will there be no meaningful stimulus, there will likely be substantial cuts in government spending.
The U.S., it appears, isn’t going to default on its debts, it will meet them, and what’s even more striking, will meet them in dollars that are not being inflated away. This is a dream scenario for bond holders, though a nightmare for the rest of us. Growth will recede and probably turn negative, making current yields on bonds more attractive, while the risk from inflation is, for a little while, small.
The Federal Reserve may make one more attempt at stoking inflation through quantitative easing, but they too are hemmed in by politics. It will be hard, politically and practically, for the Fed to act in a way that actually rekindles inflation. QE2 must be counted a failure, and a failure that put the Fed’s cherished independence in the firing line. More likely the Fed will act, and this may come this week, if a new banking crisis forces it to act as the lender of last resort.
Prices really told the story on Monday; the S&P 500 fell nearly 6 percent while the yield on the benchmark 10-year Treasury note fell by an astounding 20 basis points to 2.35 percent. That very low yield reflects the belief that the U.S. will not borrow huge sums to stimulate the economy, and that the economy will likely suffer greatly. That suffering is not solely because of a lack of stimulus, it is because the banks are too hobbled to play their role, and consumers are too overstretched to take up any slack.
This is a balance sheet recession, and it will be grinding and ugly.
TAKING THOSE TOO-BIG-TO-FAIL BETS OFF THE TABLE
More striking still was the behavior of stocks and derivatives tied to banks commonly thought to be classed as too big to fail. Their shares fell strongly, while the cost to insure them against default rose. Shares in Bank of America fell by more than 17 percent, Citigroup fell 15 percent and JP Morgan fell by 8.5 percent. The cost to insure Bank of America against default was at one point quoted at 290 basis points, up 100 basis points on the day.
Those prices reflect a number of things. A deteriorating economy will be bad for bank profits for a start. They also likely reflect the growing chance that the U.S. will be unable or unwilling to act as a guarantor to keep TBTF banks alive regardless of conditions. That has been the unwritten agreement since at least early 2009, that banks would be kept alive and allowed to earn their way out of their difficulties. A U.S. which has a lower credit rating and less willingness to borrow is a U.S. which is less likely to underwrite a second bailout without wiping out equity holders and very possibly making bond holders pay as well. Interestingly, the cost of insuring against a U.S. default remained broadly steady on Monday at 57 basis points.
French default insurance, in contrast, soared, despite its still being AAA rated, to almost 160 basis points, while shares in major, and presumably too-big-to-fail, bank Societe Generale slumped severely in U.S. trading. The presumption here may be that France, which looks in line to absorb the huge cost of an Italian and Spanish bailout, may be downgraded, and in turn may be a poorer backstop for its large banks. Britain, which also has a banking system that dwarfs its economy, also saw its cost of default insurance rise while shares in its leading banks tumbled.
Solvency of banks in a fiat money system with insurance is, ultimately, governed by the states’ will to keep its banks afloat.
Let’s hope that a disorderly cross-border bank failure is unthinkable, and that the current cast of characters will be galvanized to action in this hopefully unlikely event.
The policies put in place last time did not work. Quantitative easing has a poor track record, but more damagingly, keeping banks alive but unable to intermediate capital properly has condemned the U.S. to poor growth, all the while allowing for three more years of looting.
Second chances in life are rare, and should be seized.
At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.