Friday, January 4, 2013

3, Jan 2013 -The fate of fiscal cliff and my expectation

3, Jan 2013  -The fate of fiscal cliff and my expectation

Equity and bonds markets not only in US but world over have been fixated over the impending fate of fiscal cliff. Given that the US public debt has reached a particular ceiling (i think its USD 16tr) the ruling govt has to determine between two equally distasteful options, either increasing the debt ceiling further or reducing the rate at which debt is accumulated, which would consequentially require reduce spending, increase taxes or both. Increasing the ceiling will provide room to increase debt and hence allow the government to follow expansionary fiscal spending mainly unemployment doles and medical bills for the uninsured. Reducing spending will have immediate repercussion in terms of riddling an already soft economy and govt balance sheet delevaraging at the same time that the private sector is deleveraging after bust in equity and house prices (primary measure of household wealth) and a high level of structural unemployment (reduces current income). Doing so would risk higher dissatisfaction among the constituency and contracting growth will put more pressure on loosing monetary policy further. With current short term rates close to zero and long term rates below expected long term inflation, every incremental dose of program to loose monetary policy further will be lesser and lesser effective.

I believe the most important goal for the govt at this moment is reducing unemployment and the monetary policy has explicitly made it clear that monetary base will keep expanding until unemployment reduces from current 7.8% to 6.5%. Any attempt to cut back on spending will not only put the future growth at risk but will also undo a large portion of what the monetary policy has been trying to incessantly achieve over the past  four years. Another important point, is that given the low real interest rate and subdued inflation expectations, its is advantageous to increase public spending now. Also any multiplier effect of higher or same public spending now relative to reduced spending will allow the economy to better cope up with higher fiscal austerity in future than reducing the spending now and pushing the economy back into a recession, reducing its earning and paying capacity in the future which will also endanger the sustainability of a tighter govt wallet in the future ineffect offsetting the primary objective of the fiscal discipline in the first place.

On the other hand, increasing the debt ceiling further will cause holders of govt debt more jittery which should be lead into selloff of govt debt, specifically, longer term debt and hence increase in yields. Additionally, the costs of selling new debt may be higher than what has previously been the case, resulting into higher and steeper yield curve in future.

But how practical is the above scenario.

for the sake of simplicity, lets classify the holders of govt debt into domestic and foreign investors. For foreign investors to disdain US govt debt would require taking a big loss on the existing value of its reserve currency, depreciating dollar (as investors dump US denominated assets and repatriate capital) would put upward pressure on their own currency and downward pressure on exports (but if all currencies appreciate in general against the dollar, the disadvantage in terms of export competitiveness may not be much). But countries particularly those that are more export oriented may be incentivised to manage their currency vis a vis dollar limiting the amount of depreciation possible with respect of atleast some currencies and the need to keep shoring up USD reserves. In a alternative scenario, lets say the many export oriented countries of today become consumption oriented and hence may benefit from higher domestic currency than in the alternative scenario. Rising domestic consumption will require progressive development of social, financial and economic infrastructure similar to that of what US and other developed world has achieved which in many countries is away by many decades if not more . Rising consumption in rest of the world plus a weaker USD will be a boost for manufacturing in US, also weaker USD will induce inflation and hence reduce govt debt burden through implicit default (since principal is to be returned in nominal not inflation adjusted dollars). Also, lack of confidence in dollar assets will require some sort of new mechanism for global monetary arrangement (where the influence or atleast the desire for influence of the large developing nations like China, India, etc. will be stronger, but almost all developing nations lack the depth and breadth of financial markets as well as respect for property laws that US has and are years way from  doing so. also none of them look like being in a consensual leadership position as of now). To conclude, the outcome or atleast the immediate outcome of increasing the debt ceiling in terms of foreign investor action is uncertain at best, though a gradually depreciating USD is favorable for both US consumers, businesses, govt and foreign holders (to the extent that they limit overtime the building of USD bubble through their own actions and ultimately own peril). The fundamentals or the disequilibrum that has caused USD strength and lower borrowing costs for US govt inspite of a deteriorating credit profile has not changed drastically now so as to warrant a selloff in the bond market by foreign participants atleast in the short term. Rising debt ceiling will raise voices about the unsustainability and prudence of doing so, but its impact in terms of market disruptions will be limited. to summarize, raising the debt ceiling has benefits that cannot be ignored

  1. supporting the economy when its needed the most
  2. future recession due to cut in govt spending will undo efforts of the monetary policy and may leave little option but to resume fiscal spending in future again
  3. low real interest rates make it an opportune time to borrow
  4. There are incentives for the foreign holders of US debt to continue the status quo atleast for time being even when real returns may be low in future from rising yields and depreciating dollar or both given the lack of feasible and consensual alternative to the dollar presently

From the perspective of domestic investors

The relevance of domestic investors appetite to hold domestic government debt is a bit of a puzzle (for the want of better word). Let say, domestic investor are wary to hold govt bond given the fiscal imprudence. in that case, bond yields on govt debt would increase (keeping foreign investor mute for time being) but that scenario would lead to higher incremental yields on all semi and non government bonds. So the question faced by domestic bond investors would be one of asset reallocation from domestic credit products to international credit products. Major developed country bonds markets outside US include Europe and Japan and maybe Australia and Canada to lesser extent.. Europe and Japan are no better than US in terms of their own fiscal prudence. Most other bonds markets even in big economies are not much liquid to accommodate trades worth billions of dollars daily. Also many countries outside US and Europe who have debt denominated in their own currencies may not be able to stand the high level of volatility that foreign capital flows may entail. Another alternative to domestic investors would be to increase allocation to equities and other asset classes at the expense of domestic debt holding, that would have implications on the portfolios price and cashflow characteristics and would engender other more complicated asset allocation challenges for large institutional investors. The above alternatives can be implemented at the periphery of the core portfolio with the extent of reallocation decision based on constrains over liquidity, volatility and price risk tolerance for given domestic investor. Also if higher yields were to destroy asset value it would simultaneously reduce present value of future obligations for domestic pension funds who are the largest domestic holders of government debt. Finally, there is nothing stopping the government from hand wringing domestic savers from financing the government through coerce policies and regulations. 

To sum it up, the near terms benefits of rising the debt ceiling are apparent and objective however the expected unfavorable outcomes of doing so in terms of investor confidence (both foreign and domestic) are a bit convoluted given the current situation. 

The risk of cutting down on spending are too great for the government and the economy to sustain. Also a contractionary fiscal policy will run opposite to the goals and objectives of a expansionary monetary policy which may do little to simulate business investments and consumer spending (given the concerns about future taxes and lower subsidies). this phenomena is currently playing out in Europe most notably in Spain. 

In case the US government decides to increase the debt ceiling versus implement fiscal austerity, the main challenge will be communicating this intention to the market as the initial response of market commentators will be on the unsustainability of the growing debt pile which could lead to further credit rating assessment and rise in yields. Hence, one possibility could be talking about spending cuts while not implementing one (remember it will be the implementation that will risk de growth in GDP) and doing some spending 'under the table' ie to say, disguised spending. 

All in all, my predictions is that the US govt will prefer rising the debt ceiling than cutting down on spending to the magnitude required to keep deficit under control (which is other way of saying rising the debt ceiling) but it may find innovative ways to communicate or not communicate this to the market. that would nevertheless result in rise in government bonds yields this year, but only modestly and I see no major dislocation in the US bond market in terms of foreign and domestic investor action even if the above scenario were to play out. 

Overtime however demand for non US bonds and equities across the world should increase its share at the expense of the US bond market but that is a steady progression and also hinges of the fate of economies and regions outside the US. 

Jan 2013

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