You Know Your Government Is in Trouble When...
The Reinhart & Rogoff “BANG” moment is defined when confidence in a government collapses. No one can predict when that moment happens as bubbles can often go on longer than most would conceive possible, but when confidence is lost things unravel quickly. Below is an excerpt from the two authors describing the unraveling of confidence in the government when debt levels become unsustainable.
"Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence…is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when BANG!-confidence collapses, lenders disappear, and a crisis hits.”
This Time is Different: Eight Centuries of Financial Folly
by Carmen Reinhart, Kenneth Rogoff
I would say that Europe reached the “BANG” moment back in 2009 first with Greece and then the greater part of Europe in 2010. The “BANG” moment for Greece is clearly visible below in which its ratings were downgraded from “A-“ to “CCC” in just two years and 5-yr bond yields rose from below 5% to more than 60%!
When confidence is lost in one’s government securities, where does one then invest? Perhaps the answer is shown below in which European blue-chip companies are now perceived as more creditworthy than their governments. This occurred in 2010 when the risk of default as measured by credit default swaps (CDS) on western European debt rose above that for blue-chip European equities (bottom panel below). At the time the U.S. also witnessed a similar situation, but the CDS for a 5-yr UST never exceeded that for the average Dow Jones Industrial Average stock.
However, the U.S. is likely living on borrowed time as we are on an unsustainable path of trillion dollar deficits. How long will major foreign holders of UST debt continue their confidence in the US government?
We may already be witnessing the early signs of this erosion as highlighted by a Wall Street Journal article this week with excerpts below:
Bonds of Exxon Mobil (XOM) and Johnson & Johnson (JNJ) are trading with yields below those of comparable Treasurys, a sign that investors perceive them as a safer bet. It is a rare phenomenon that some market observers said could be the beginning of a new era for debt markets. It could ultimately mean some companies will borrow at lower rates than the U.S. government…
Money is pouring into highly rated U.S. corporate bonds at an even faster pace than Treasury debt, according to fund-tracker Lipper, as buyers clamor for investments perceived as safe that typically also yield a bit more than Treasurys. A shrinking supply of top-rated debt is also driving investors toward the highest-rated U.S. companies. That demand has driven up bond prices and pushed down yields.
The soaring demand has enabled companies of all sizes to raise $1.2 trillion from issuing debt this year, already the busiest year on record, according to data provider Dealogic. U.S. corporations, now sitting on $1.73 trillion of cash and borrowing at the lowest rates in history, are arguably in the best shape ever…
Bonds of Exxon coming due in 13 months were quoted on Tuesday at 0.01 percentage point less than the comparable Treasury, according to Benchmark Solutions, a pricing service. Bonds of Johnson & Johnson due in May 2014 also recently traded at 0.01 percentage point less than Treasurys. Both are rated triple-A by S&P..
According to Credit Suisse, the share of world-wide government debt rated triple-A has fallen to 39% of the total from 58% in early 2010.
Corporate bonds "are definitely the new safe havens in this world," said Fer Koch, director of U.S. credit strategy at Credit Suisse.
While the CDS on a 5-Yr UST may be below the average DOW stock, there are several DOW companies that are perceived safer by the credit markets than Uncle Sam. The current CDS for a 5-Yr UST stands at 37.35 basis points which is higher than eight DOW stocks shown below with Merck (MRK) currently at a meager 15.50 basis points.
Unless the U.S. wants to have its own “BANG” moment it better get its house in order with true budgetary reform and move past the fiscal cliff. How much time the U.S. has is anyone’s guess but the fact that nearly one third of the Dow Jones Industrial Average companies are perceived as safer than our own government likely indicates that the time to act to prevent the “BANG” moment is rapidly eroding.