A High Stakes Game of Chicken


“May you live in interesting times.”
Chinese Proverb

“They will definitely reach a compromise. Don’t worry too much about it.”
July 24th, 2011, by Xia Bin, an academic adviser to the People’s Bank of China, the largest foreign owner of U.S. government debt, with $1.16 trillion invested in US Treasury debt as of May.

So, here we are with one week remaining before the clock runs out on the current US debit ceiling of $14.3 trillion, and politicians, as they are inclined to be, are being politicians. Each side of the Congressional aisle no doubt has objectives for the negotiation that are firmly rooted in political ideology, but also has other objectives that are less ideological and more political in nature (e.g., extend the next debt ceiling deadline past the 2012 election cycle, walk away being able to claim “victory” in the negotiations, etc.), and world financial markets wait with bated breath.

There are several reasons why this is an important issue. The most immediate of these is that a US default (even a politically caused, short-term, technical default, as we’d be looking at here, as opposed to an actual economic default as is the case in Greece) would likely cause significant disruption, both psychological and economic, to global financial markets. Although the global equity market is large, the global bond market is orders of magnitude larger, and a US default would send shock waves through both, and at least in the near term, would lead to undesirable and unpredictable outcomes in economies worldwide. The second, and longer term issue, is the AAA credit rating of the US government and the increased cost of borrowing that would result from even a small ratings decrease. Higher borrowing costs would lead to greater costs for the government and ultimately for businesses, and these in turn would likely lead to a further need to increase the debt ceiling, higher taxes, fewer resources available for government programs and a decrease in consumer spending and corporate earnings, none of which would be good outcomes.

And yet despite the dire potential outcome of Congress and the White House failing to come to terms, world financial markets have largely yawned at the prospect of such an event, with the S&P 500 only 3% off its recent high, and US Treasury rates remaining near historic lows (2.8% for a 10-year US Treasury bond vs. 2.9% for a 10-year “risk free” German government bond). Additionally, the cost for credit default swaps (essentially insurance against default) on US Treasury debt, while having risen over the last few months, is still cheap by most any standard. Were markets and investors across the globe more concerned about an actual default, you’d expect to have seen larger losses in world equity markets, higher interest rates on US government debt, and more substantial cost increases on US credit default swaps, and yet we’re not seeing any of these so far.

Generally, I have a policy of not writing anything too topical until I get at least five phone calls or emails about a particular subject, and so far, the US debt ceiling issue and the possibility of default has (surprisingly) only come up in three conversations to date. Had you told me three months ago that we’d be sitting here with one week to go prior to the August 2nd debt ceiling deadline with politicians involved in a game of very high stakes chicken, I would have predicted much more turbulence in world markets than we have seen. None-the-less, the few conversations I have had with clients have, not surprisingly, been around the question of what can we/should we do about this possibility. Given the vast amount of news coverage about the topic, and the sense of background anxiety around the issue, I thought it worth commenting on.

There are, of course, an unlimited number of potential outcomes here, but I think the most likely two scenarios are: 1) Congress and the White House, at or close to the last minute, come to terms that will avoid a technical default on August 2nd and which will achieve substantial budgetary cuts, or 2) They continue to squabble up to and right past that point, at which markets will produce a resounding thunderbolt, at which time Congress will do what they did in the fall of 2008 when they initially voted down the TARP bailout bill on September 29th, only to see markets plummet 800 points. Within two days, they had approved the bill, and markets promptly regained 500 of those 800 lost points. In either of the two scenarios I outlined above, markets will almost certainly be choppy at least until some resolution is reached, but keep in mind that it’s difficult to predict even what would appear to be obvious as the market’s recent relative stability has shown.

I think the natural inclination investors tend to have in situations like this is, “Why not get out and wait it out until things look clearer/safer/better and then get back in?” There is no question that that would be the most defensive thing to do, although such a course is not without its own risks, as I saw with clients who pursued such a course of action during the meltdown of 2008-2009. In no case did I see anyone who pulled out of the market during that very difficult time or who stopped an ongoing investment program end up being better off for having done so, and in a few cases, I saw such decisions result in hundreds of thousands of dollars in foregone gains or locked-in losses. Just like then, today’s investors – large and small, institutional and individual – face a given set of circumstances, an uncertain set of outcomes. I think what ultimately separates the investor from the speculator is the time horizon over which decisions are made and evaluated. If we go back just two years, those who left the markets in 2008 or early 2009 may have felt better, and even been better off financially, over the ensuing two or three months, but in most cases (all cases that I have personally seen), are worse off for having done so over the ensuing two or three years.

As always, I’d be more than happy to talk over in more detail if that would be helpful. Please let me know if you’d like to do so, or if there is anything else I can do for you.