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A member of the Euro zone has defaulted while pressure is building on others and a U.S. government default is in suspended animation. Since a U.S. default would be a willful strategic act it can be avoided, but even if avoided, it leaves the market with a stronger sense of U.S. sovereign risk. Indeed, Egan-Jones has already downgraded Treasuries irrespective of the debt ceiling issue. This is what financial history is made of, if two major reserve currency countries have a simultaneous sovereign default. While watching in awe, investors then determine the flight to quality asset in the global financial marketplace.

This will not merely be a sell-off by individual investors of reserve currency assets. It will be much larger than that, since leveraged financial institutions such as banks hold significant proportions of these assets, and hence bank short term funding sources demand repayment. That means asset sales and lower prices of the assets held by financial institutions to meet their liquidity drains.

These are circumstances similar to those of the Lehman Brothers week-end: Central banks are then called in to lend to commercial banks and other financial entities, including hedge funds, that face fleeing depositors and other short-term lenders in addition to the pressures to monetize government debt. This in turn explodes the central bank balance sheets. In the case of the 2008 meltdown, the Fed’s balance sheet exploded by approximately $1trillion to lend enough to stabilize the selling. Again the money pump goes to work, and we now see how inflation can be created in the absence of excess demand in goods markets in the reserve currency countries.

Hence, the investors’ problem is not simply to find another country that doesn’t have fiscal strains, whose banking system is well capitalized and doesn’t hold sub-prime sovereigns. The contraction then puts into play a meltdown in otherwise performing assets denominated in the reserve currencies.  Hence, sovereign risk is not only joined at the hip with inflation risk, but also with market volatility, with most of the volatility on the downside.

That being the case, until the U. S. deficit, debt, and threat of default are resolved satisfactorily, the usual flight to the U.S. dollar and the Treasuries will not take place. Indeed, the dollar has not been gaining relative to the Euro as it did in 2008. The market is seeking flight quality alternatives to both dollar- and Euro-denominated assets.

To qualify as a systemic flight to quality asset, the asset should have liquidity and should also be somewhat immune to or benefitted from inflation. That amounts to a tall order of non-Euro, non-dollar, liquid, high-quality and inflation-proof assets hopefully bearing a current return. To be sure, these assets will be relatively scarce so price appreciation is likely if the market turns to the flight assets.

Precious metals would be an obvious choice along with global inflation indexed debt. The focus would be income producing real assets in flight countries such as Canada, Brazil, Australia, New Zealand, the non-Euro Nordic countries, Switzerland and various Asian countries.

I have asked Frank Beck of Beck Capital Management to provide us with the benefit of his work identifying viable flight to quality candidates. His blog is entitled While Governments Fiddle, Debt Burns .



Reserve Currency Sovereign Defaults and the Flight to Quality Asset — 15 Comments

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