US Sovereign Risk: How the Market Reins in an Out of Control Sovereign

While it is relatively easy to legislate entitlements, paying for them is the more difficult part and obviously little thought was given to the latter at the time the entitlements were passed into law. Moreover, little thought was given to the process by which the growth of debt exceeds the growth of income and sets up the dynamic process that impedes the ability of the economy to grow as reviewed in
Sovereign Risk Part 2.

Given the legislated US sovereign debt growth relative to income and the built in regulatory and expectation bias that supports Treasury offerings in the market, at some point market forces will rein in the government’s debt accumulation growth relative to the income base. The question is how the market reins in the sovereign.

There are a few ways the market can rein in the government just as it reins in an out of control corporate entity whose debt grows faster than the ability to service the debt. The most likely constraint on the government occurs when Treasuries become discounted in the secondary market which is to say sovereign risk is priced into Treasuries. This in turn causes the terms of finance for the government to deteriorate (financial costs rise) which quickly spreads to a major portion of the existing outstanding Treasury debt because so much of it is very short maturity requiring refinancing at the new higher market rates.  This in turn causes deficits to grow and the added supply of additional unplanned Treasuries relative to income must be financed. We are then borrowing to pay not only principal but also additional interest. This is better known as a Ponzi scheme that requires exponential increases in participants to sustain it.  The added supply of unplanned Treasuries relative to saving in turn further deteriorates pricing.

This describes an “orderly” unraveling of the ability to finance the government but there are ways the market can act more quickly and decisively but through another mechanism. This would simply be the desired sale of Treasuries on the secondary market accompanied by a fear of being invested in Dollar denominated assets. This expectation emanates from one who sees the bigger pictures of what happens to market value of wealth in a country that is or likely to increase taxes, accompanied by slower growth and the above discussed Ponzi Scheme financing with or without the pressure to monetize the debt.

That is, capital outflows from US dollar investments take place which sets up a powerful dynamic to rein in the government debt sales.  For those who do not believe the market will run the dollar and dollar investments, it began in 2009 as the dollar fell 15% against a basket of currencies.  Capital outflows are a humbling experience and one could look at other examples.  The experience of the Emerging Market countries in the second half of the l990s in particular demonstrates the effects on an economy and financial market.

What follows is a net sell off of assets in the flight currency, a deterioration in wealth and hence spending, an increase in the cost of capital and a decline in the market value of the Mexican Inflation Indexcurrency (or a rise in the price of the go-to currency.) This is a powerful adverse combination that results in stagflation (a recessionary inflation).  The recession occurs because wealth declines in value and less spending follows, the higher cost of capital reduces investment spending and the recession along with declining values of market assets causes bank distress and the loss of a viable lenders.  The inflationary part of stagflation occurs because the price of foreign currency becomes more expensive and imported products for which there are no domestic substitute hence becomes more expensive leading to what is known as import inflation.

The extent to which capital flight can cause inflation and higher interest rates was demonstrated when capital fled the emerging market countries in the mid to late l990s.  Capital flight first hit the EMCs with Mexico in late l994, the Asian Tigers in fall of l997 and late in the decade in Brazil and Argentina and lastly Turkey.  The following graphs give an indication of the higher interest rates and inflation that follow by using Mexico as an example.

28 Day Cete YieldNote that both in 1986 and in 1995 did both the inflation rate and market yield spike and this rate is on the short term sovereign Cete which is Mexico’s sovereign.  No doubt longer term corporate debt spiked even more so making bankruptcies inevitable at those multiple leaps in the cost of capital.  With wealth crushed, the banks insolvent, rampant import inflation and the cost of capital at rates that would not permit investment spending, the economy went into an inflationary recession.

While capital outflow effectively stops the sovereign and the economy, it is possible for the market to stop the economy as the result of a failed auction of newly issued Treasury debt rather than a secondary market flight.  That is bids, for a new government debt offerings could dry up. That is the bids relative to the debt being offered results in a failed auction.

This indeed occurred with the UK in 2009 which resulted in an almost immediate sovereign rating downgrade and a re-pricing of the UK sovereign debt.   The deterioration in the terms of finance is recognition of sovereign risk because if future auctions fail, there would be no way to redeem principle on existing outstanding debt.

The end-game for a government when the market turns against its debt then depends on whether the government can monetize its debt. That is the question of whether there a central bank it controls that can print money to purchase the government’s market debt which depends on whether the government’s debt is denominated in its own currency.
There are two scenarios. Let us take first the scenario of when the government’s debt is denominated in another currency that it does not control.  This would be the case for California, Greece, and Argentina though for different reasons.  With California’s debt not being denominate in US Dollar Fed support for California debt is a policy outside existing legislative mandates but that mandate could be changed by Congress.

The case of Greece is very interesting in that it also is without its own central bank support and is like Californian dependent on a European Central Bank (ECB) monetization which also to date has not occurred directly though the ECB like the Fed creates money through the purchase of the individual country’s debt. By their charter, to qualify for a monetization the government debt purchased must be rated investment grade so Moody’s and Standard and Poor’s have enormous power over the fate of Greece’s entitlements and deficits. As a result the ECB is creating its own rating system no doubt to make it possible to finance a Greek bailout if desired.

Argentina is another interesting example of debt denominated in a foreign currency. Years ago, foreign investors with a perception of not taking currency risk by investing the Argentina’s debt caused Argentina (and others) to issue debt denominated in US Dollars.  When Argentina’s debt sales hit the wall, capital fled from Argentina and hence US dollars became very expensive for Argentina’s government to purchase in the wake of a capital flight stagflation.  There is a secondary market for the defaulted Argentine debt but basically there is little chance that Argentina unless bailed out by the US government or the Federal Reserve will ever pay off more than a fraction of its stated maturity value.
The implication for a country with a failed debt offering with its debt denominated in the home currency then depends on the support from the central bank. That is, will the central bank monetize the debt and if not, will the government somehow gain control over the central bank so that the monetization takes place. If so the message for the investors is still problematic in that the government bond holders will now receive principle repaid in a currency that is will be debased. That is, inflation will result so that the real value of the government bonds if held to maturity will decline and the secondary market will immediately price in the inflation risk.

For the US, the issues then are the willingness of the Fed to monetize or continue to pursue objectives of inflation control.  The very ability to turn down the government or Treasury Department pressure to finance the deficit by printing money goes to the heart of the independence of the Federal Reserve.  Independence is the ability to say no.  The investors in the market are no doubt gauging the willingness of Bernanke and the present Board of Governors to say no.  It seem quite clear from Bernanke’s recent testimony pursuant to his confirmation for a second term that he is drawing a line in the sand and will say no.  He spoke of the responsibility of Congress to contain deficits to 2.5 to 3% of GDP implying that he would not fund anything beyond that.

If pressured and he does not budge there then is the question of what it would take to replace him with a central bank chairman (for example as recently done by Mexico) to carry out the monetization. Since there currently are 3 openings on the 7 person Board of Governors and two prior Obama nominees, it seems that he could be outvoted if he resisted.  As an alternative, if the Fed still refuses to monetize, simply an amendment to the Federal Reserve Act to change the Congressional monetary mandate to include government bond support would be enough to change behavior at the Fed but it would likely still be trumped by capital outflows from the US.  The Fed owns about 5% of Treasuries outstanding and an exodus of private investors would substantially add to the quantity of Treasuries the Fed would need to purchase and correspondingly ramp up inflation expectations. Hence in the end even if the Fed steps in there would likely be the ill effects of net capital outflows as outlined above that result in stagflation.

It is worth pointing out this has happened before in the US.  Shortly after WWII began the Fed voluntarily stepped in and announced the Bond Support Program to keep providing bids in the secondary Treasury market to support Treasury prices so that Treasury debt yields would not rise above the existing yields that then existed.  In another episode of major deficit stress of deficit, during the Civil War, Congress gave Treasury the power that it used to print currency rather than issue debt, that is a direct monetization of the deficit.  Since this is the outcome of a government under financing stress there is little reason to believe that it will not again occur.

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