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Forex Blog - US Sovereign Credit Risk Scare?

US Sovereign Credit Risk Scare?


In both the case of Bear and Lehman, few could have predicted at how fast the Wall Street giants could collapse when market confidence in these firms evaporated.  Is the US any different?  Can world markets wake up tomorrow and decide that US imbalances, leverage and now monetization are no different than Bear and Lehman mortgage market exposure and leverage that brought these firms down. 


To some extent the US is vulnerable to a run on its currency and assets much as highly leveraged and undercapitalized investment banks were to their exposure to bad mortgages, real estate and highly toxic credit derivatives.  But one day of selling of the dollar, stocks and bonds does not make a market run on the US.  A sovereign run is a tip of the tail event for a large industrialized and diverse economy like the US.  Anything is possible and some things are like a collapse in US assets and the dollar should not be ruled out in light of the current budget math, growth outlook and dependence on foreign capital.  But this does not make a run probable. 


It seems to me there is some credit risk being priced into the dollar and bonds and this has been a risk for some time.  But pricing in some risk US loses its AAA rating to AA from highly discredited credit rating agencies, is not the same as pricing in Weimar Republic or Zimbabwe outcome for the US


Still because US imbalances are so large and Fed and Treasury policy all in on credit and demand, there is not a lot of room to maneuver for US asset prices, the dollar, the policy response and the real economy without creating undesired disorderly adjustments in capital markets.  Thursday was borderline disorderly and surely put US officials into an elevated state of alert. 


So today when only bonds and the dollar are getting crushed we can breathe a little easier. 


Still we should see more scope ahead to price in credit risk for the US and see declines in the dollar, stocks and bonds and this leaves open the chance of episodes of disorderly adjustments…just not the end of the world as we know it.


What seems to be happening, however, is a change in the narrative…what makes markets do what they do (regardless of the reasoning…faulty reasoning has the capacity to drive financial markets and currencies far longer than most anyone can stay in a more rational trade).  The narrative change seems to be exiting risk-aversion theme for sovereign risk theme. 


If I had to break down where markets have been in terms of key themes or narratives since the credit crisis unfolded and morphed into an economic crisis I see three distinct phases.  The first and longest lasting was the life or death of capitalism period when the banking system verged on self-destruction on at least two occasions – after the failure of Lehman in the fall of 2008 and in early March in the stock market capitulation low.  This phase was largely about avoiding risk and covering exposure (huge net dollar exposure as it turned out).  Get fetal, get cash (USD) and stay alive.  The second phase was policy-related – now that policy makers avoided a collapse in the system by underwriting weak large banks too big to fail, the focus shifted (narrative changed) to how can officials get banks and the real economy going again.  This period, where risk aversion also reigned supreme in pricing assets and FX, focused mainly around the credibility of the policy response – deeply questioned to the near demise of equities through early March as the Obama administration struggled to get its arms around the crisis with the help of a suddenly highly doubted new Treasury Secretary Geithner.  The third phase is one where the administration has responded forcefully if not smoothly and succeeded in turning sentiment in favor of recovery and the survivability of the banking system (no one is even talking about bad bank assets and PPIP…it is assumed that the patient has survived and faces uncertain rehab ahead).  In this phase the markets are questioning the exit path.  How does the US Treasury and Fed unwind some $12trln in cash and insurance thrown at the problem get unwound without seriously damaging if not killing the dollar, Treasuries and the economy/stocks?   Will this buy a sustainable recovery in the real economy that supports earnings and incomes ahead?  This new phase is not primarily a risk aversion trade.  Indeed the more perceived US sovereign risk, the lower US assets and dollar.  In the prior two phases elevated risk saw capital run to dollars and Treasuries (and out of equities).   I suspect the days of blind risk aversion-based trading are over and the new sovereign risk world is here and tied directly to a post crisis exiting of massive stimulus that pose great risks to US debt, equity and the dollar. 


I can see in fairly short order markets beating a new drum in Washington not unlike the one they beat in January-March – tell us what your thinking…what is your exit plan Mr Fed and Mr Treasury…we want details and soon! 


Sadly the success of getting the real economy back into the leading role in the economy and replacing the government depends to a great extent on keeping market rates from rising much more – higher bond yields in due course could prematurely kill the recovery. 


No one ever said this would be easy to more or less borrow from Cold Play.  Markets have a knack for disrupting the best made plans of officials.  Short of the Fed really swarming over the bond market more permanently and buying trillions more in bonds, it is hard to see how the Fed can thread the needle.  And the outcome if they don’t thread the needle?  A lost decade. 


Markets are being rewarded for pressing bets on the Fed and Treasury not getting it right and the lost decade the more likely outcome.  Going back to the days of risk aversion seems unlikely from here.  Supply, anemic recovery, structural imbalances, household and firm (banks especially) balance sheet adjustments, absence of exit strategy details and sovereign rating risks are what will dominate thinking ahead and these stack up at this early stage of the new phase as decidedly bearish for US Treasuries, the dollar and stocks.  There is plenty of downside to price in between where we are today and a Weimar Republic or Zimbabwe outcome.


David Gilmore


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