Tuesday, May 4, 2010

Sovreign Debt: "A glimpse into financial hell"

From FT Alphaville:

Alan Ruskin has peered into the abyss of a US sovereign debt crisis to see what the world might look like. Unsurprisingly, it’s not a nice place.

Food commodities would be about the only thing left worth owning, according to the RBS strategist.

Now, Ruskin is not forecasting a 70’s style Treasuries sell-off, but he reckons this is a fat tail risk worthy of serious consideration given that politicians will need to have their feet raked over coals before behaving responsibly.

Welcome to financial hell:

The US Treasury market is large, but by the size of global financial assets it is still surprisingly small. If we use end 2008 IMF data (because this data is complete and the last year will not have changed the big picture) US treasuries make up 25% of global public sector debt securities; 9.5% of public plus private sector debt securities; 7.5% of bank assets; and a modest 3.5% of all private & public sector debt plus equity plus bank assets. In other words there are plenty of other assets to own in the world. However, that would not help much if there was a run on US treasuries.

The first problem is simply one of correlation. Almost all the above assets, private debt, bank assets and equities will be especially highly correlated with US Treasuries in a crisis. The second problem is that Treasuries, even if they stand at the epicenter of the crisis, are likely to be the low beta asset. The majority of the $220+ trillion in global bond, equity and bank assets would be leveraged off global growth and remain high beta relative to Treasuries, losing even more value were Treasuries to collapse. This probably also applies to many real assets in the short-term, especially those that are interest rate sensitive.

A Treasury collapse story presumably would very quickly evolve into too many risky assets chasing far too few ‘risk free’ assets. What are the risk free assets they would choose? Gold, the barbaric metal, would presumably feed handsomely off such sovereign risk savagery! But the total gold market is estimated to be only about $6.5trillion, or smaller than the Treasury bond market, of which only a little over $5 trillion is in private hands. Worse still, the daily gold turnover is only 2% of major currencies! Such a slow churn, coupled with fixed supply, would drive prices parabolic, and the choice of buying gold would quickly start to feel like it did to the average Dutchman in the 17th century, when a single tulip rose to an average of 10 times annual income.

Foreign bond markets could provide an alternative, if tax revenues could hold up somewhere in the world, but all debt markets outside the G3 are tiny relative to global assets. For example even the German Bund market makes up less than 2% of global debt securities, and this is roughly three times all of Asia NIC public debt if you were looking for an emerging market ’safe haven’. In a topsy-turvy world where the risk pyramid inverts, and the developing world risk converges further versus the developed world, emerging economy bonds, equities and bank assets still provided limited opportunities, making up a mere 14% of these same developed world assets.

And here is Ruskin’s conclusion:

The above clipped analysis tends to lead to an unlikely conclusion: One of the unique sources of Treasury value, is that as it goes down, it destroys more value in most substitutable assets than it loses itself, which perversely then provides some support! Put another way, one of the sources of Treasury ‘quality’ is precisely its ability to destroy value (quality) in competing assets! In the hierarchy of assets it makes a difference whether assets are dependent on other assets, or whether they lead other assets, as the Treasury market does. It is also doubtful whether another benchmark sits in the wings, for no other economy is big enough and has the global interconnectivity whereby changes in the long-term price of money reverberate around the world the way US treasuries do.

Now a US Treasury crisis should also never have to extend to default, as long as the Fed is willing to buy US Treasury debt, and deliver the haircuts to investors through inflation rather than direct restructuring – which may be preferable for reputational interests. Unfortunately the inflation route is still desperately painful, not least because it drives up nominal yields and delivers the pain incrementally through bond and currency losses, rather than all upfront as a restructuring. Such bond losses are indicative of how a fiscal funding crisis quickly ends up as a monetary policy crisis, and a collapse in central bank control across the curve....MORE