How Innocuous Is a Treasury Default?

Steven Englander, Global Head of G-10 FX strategy for Citi is not very sanguine about a Treasury default, especially as it pertains to foreign holders of Treasurys. From an email today (not online):

We argue below that the impact of a debt ceiling breach may be larger and more permanent on the dollar than on fixed income markets. So it is worth going through the analysis, even though the dollar has so many immediate problems that it seems unnecessarily rude to bring up a problem that may not emerge for another couple of months.

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What intensifies the risk is that Congress and investors may be coming to see policymakers as wearing a safety harness as they jump off the debt ceiling cliff. If the financial market reaction is too negative, Congress can have a quick session of mutual recrimination and quickly vote a debt ceiling increase. If policymakers convince themselves that the consequences are reparable they are more likely to take risks. Statistically, there is greater willingness to do bungee jumps than suicide leaps, although very rarely one unexpectedly turns into the other.

We would like to raise the possibility that the impact of a debt ceiling breach could easily fall more on the USD than on fixed income markets. The reason is that unhedged foreign investors in Treasures will not be wearing the safety harness that domestic fixed income investors might be, and may see their losses as having much higher risk of being permanent.

First, consider how the optimists see a breach playing out on short- and medium-term fixed income Treasury securities. Unless an extended breach is expected, many domestic investors will see buying opportunities on any drop in fixed income prices. If the expectation is that a back up of yields would lead to a quick lifting of the debt ceiling, then many investors would see the higher yields as a buying opportunity. Coupons will be paid and any delay quickly made up.

Given how much unused credit there is, one could easily see financial institutions lining up to give loans on the back of Treasury collateral. So businesses and investors that needed the money would be able to borrow on or sell off possibly technically defaulted Treasury collateral.

The perspective of unhedged foreign investors, with currency risk, likely will be much less benign. Many of the arguments in favor of a debt ceiling breach reflect the extremely small probability that Treasury owners will be out significantly in a cash flow sense from such an event.

Foreign investors will see 1) an additional unwanted tool of macro policy added to an already impressive array of non-orthodox policies; 2) another US policy debate that entirely centers on US domestic political convenience and ignores the interests of foreign investors; 3) confirmation that US policymakers favor policy options that will almost inevitably weaken the dollar, even while swearing up and down that they adhere to a strong dollar policy and are simply targeting domestic objectives. (You are about as likely to see a Higgs boson smiling out of your morning coffee as find an instance where the US policymakers of either party made a policy move intended to strengthen the dollar. …

Most importantly, 4) while a domestic bond investor can be made whole in a cash flow sense with virtual certainty, there is no way that unhedged foreign investors can be guaranteed that any FX market reaction will be unwound similarly. Domestic investors may have some reason to see themselves doing as doing a bungee jump, but foreign investors are not sure whether the tension limit is set for 200 feet above the ground or 15 feet below.

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House Majority Leader Cantor has a different view:

Cantor said he wasn’t concerned about a negative reaction by the bond market if talks between congressional leaders and President Barack Obama continue closer to the date Treasury says it can no longer borrow money to pay U.S. obligations.

As does Representative Toomey a few days ago:

The “Full Faith and Credit Act” introduced by Toomey in the Senate and Rep. Tom McClintock (R-Calif.) in the House would essentially serve the same purpose as the House Republican “troop funding bill” did in March – it would shift responsibility for a potential default onto the shoulders of Democrats and the White House by calling on the Treasury Department to make only principal and interest payments past the Treasury Department’s Aug. 2 deadline.

In his AEI speech Wednesday, Toomey argued that the measure would “take the specter of default on our debt off the table.”

“It simply instructs the treasury secretary that in the event that we do not raise the debt limit upon reaching it, the service of our debt will be the highest priority,” Toomey said.

He added that “as a former government bond trader and someone who stays in touch with this market, I can promise you the bond market knows the difference between some kind of payment obligations and defaulting on our debt. … Those kinds of postponements are not the same thing as defaulting on our debt.”

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And, as noted in the Minnesota Post:

Michele Bachmann, speaking via the Internet to a gathering of Iowa Republicans, said a hard vote against a debt ceiling increase would show that “of all the nations, it’s the United States that’s going to get serious” on fiscal issues.

How Innocuous Is a Treasury Default?

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