Friday, August 05, 2011

More reading the yield curve as a tea leaf

**UPDATE. I wrote this top part just before 4pm today when it was unclear what S&P would say.**
Today's curve. I will call this "fiscal policy failure:"

Gold fell today, and stocks were mostly down all over the world, so my own guess here is that people dumped longer-term Treasuries for cash. That would actually be monetary policy failure. Very little risk of inflation combined with heightened doubt about the U.S.'s long-term creditworthiness could create a steepening of the curve like this.

Though I don't like his jumping to conclusions, I can agree with much of what Tyler Cowen writes here. My own hypothesis the last few years has been that Congress won't deal with entitlement spending/health care costs (ie: the long-run deficits) until they face rising real interest rates. Anyone touching Medicare/Medicaid is at a first-mover disadvantage because they immediately become demonized as a senior citizen hater.

But I do not buy the notion that ratings matter that much. A Treasury downgrade means that mutual funds will be dictated by their prospectuses to rebalance their portfolios by buying more Treasuries since their overall weighted average rating would fall. There are no available assets more safe than U.S. Treasuries-- other than straight cash. Cash is only a good store of value when inflation (and economic growth) is expected to be quite slow.

*UPDATE at 7:56 CST**
The U.S. is downgraded by S&P. The worry now, just like with the default hypothetical, is over things like the $500 billion repo market, where Treasuries are collateral. FT Alphaville wrote this during the debt ceiling debate. They were focusing on Treasuries as collateral for Fed discount loans and speculated a downgrade could cause trouble. The Fed typically requires AAA debt as collateral, but I've read that the AAA rating doesn't apply to the Treasuries, and if you read the Fed's guideline document you can see no eligibility requirement for them.

In short, we'll get a good sense on Sunday evening when our Asian trading partners, who own a large part of our debt, open their markets.

**UPDATE at 9:15 CST**
The Wall Street Journal posts this good summary with this closing (emphases mine):
"J.P. Morgan Chase & Co. analysts estimate some $4 trillion worth of Treasurys are pledged as collateral by borrowers such as banks and derivatives traders. If that collateral isn't considered as high quality by lenders, the borrowers could be required to cough up more cash or securities to put the minds of lenders at ease.

That could force investors to sell off other assets to come up with the money. In a worst case scenario, credit markets could seize up, as they did during the Lehman Crisis.

Money market funds held by millions of Americans hold some $1.3 trillion in securities directly or indirectly exposed to Treasury and government agency securities, as well as short-term loans to financial institutions, known as repos, which are backed by Treasurys. Experts say that the downgrade won't force money market funds to sell. But there are still risks.

If Treasurys tumble in value, funds will be forced to mark down their holdings, raising the potential for some to "break the buck" as the Reserve Primary fund did during the worst of the financial crisis."

Good luck, everyone.

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