Thursday , December 13 2018

Tremors

Summary:
A debt crisis does not come slowly and predictably. This year's short term bond holders, a very risk averse lot, are mostly interested in whether next year, new bondholders will show up in a year, to lend the government money to pay this year's bondholders back. They can run on small news.When bondholders get nervous, ...

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A debt crisis does not come slowly and predictably. This year's short term bond holders, a very risk averse lot, are mostly interested in whether next year, new bondholders will show up in a year, to lend the government money to pay this year's bondholders back. They can run on small news.

When bondholders get nervous, they demand higher interest rates. More than higher interest rates, they diversify their portfolios, or just refuse. Debt gets "hard to sell" at any price. A different class of bondholders, willing to take risks for better rates, must come in.

As interest rates rise, interest costs on the debt rise. At $20 trillion of debt, when interest rates rise to 5%, interest costs rise to $1 trillion dollars, essentially doubling the deficit. That makes markets more nervous, they demand even higher interest rates, and when that spiral continues, you have a full blown debt crisis on your hands.

Short term debt compounds the problem. Since the US has borrowed very short term, interest increases make their way to the budget more quickly. If the US had borrowed everything in 30 year bonds, the spiral mechanism from higher rates to higher deficits would be cut off.

The crisis typically comes in bad times -- when in a war, recession, or financial crisis, the government suddenly needs to borrow a lot more and markets doubt its ability to repay.

But there is a case for a crisis to happen in good times as well. We have known for decades that the fundamental US problem is promised entitlement spending far beyond what our current tax system can fund. Markets have, sensibly I think, presumed that the US would fix this problem sooner or later. It's not that hard as a matter of economics. Well, say markets in 2005, OK for now, you have a war on terror and a war in Iraq on your hands, we'll trust you to fix entitlements later. Well, say markets in 2012, OK for now, you're recovering from a massive financial panic and great recession. We'll trust you to fix entitlements later, and we'll even lend you another $10 trillion dollars. But what's our excuse now? At 4% unemployment, after 8 years of uninterrupted growth, if we can't sit down now and solve the problem, when will we? Markets have a right to think perhaps America is so fractured we won't be able to fix this in time. Or, more accurately, markets have a right to worry that next year's markets will have that worry, and get out now.

All this is well known, and most commenters including me think that day is in the future. But the future comes often quicker than we think.

With that prelude, two pieces of news strike me as distant early warning signs. Here, from Torsten Sløk's excellent email distribution are two graphs of the bid-to-cover ratio in Treasury auctions.

Tremors


Tremors
Torsten's interpretation:

The first chart below shows that the bid-to-cover ratio at 4-week T-bill auctions is currently at the lowest level in almost ten years.... demand is also structurally weaker when you look at 10-year auctions, see the second chart. The main risk with issuing a lot of short-dated paper such as 4-week T-bills is that in 4 weeks it all needs to be rolled over and added to new issuance in the pipeline. In other words, the more short-dated paper is issued, the bigger the snowball in front of the US Treasury gets. 
Things are so far looking ok, but the risks are rising that the US could have a full-blown EM-style fiscal crisis with insufficient demand for US government debt, and such a loss of confidence in US Treasury markets would obviously be very negative for the US dollar and US stocks and US credit. The fact that this is happening with a backdrop of rising inflation is not helpful. Investors in all asset classes need to watch very carefully how US Treasury auctions go for any signs of weaker demand.
The last part is the mechanism I described above. As an ivory tower economist, I tend to overlook such technical issues. If the bid to cover ratio is low, well, then that just means we need higher rates. But higher rates aren't a panacea as above, since higher rates make paying it back harder still. As I look at debt crises, also, it isn't just a matter of higher rates. There comes a point that people aren't buying at all.

Again, we're not there yet, and I think we have a long way to go. But this is a little rumble.

The second tremor is Why International Investors Aren’t Buying U.S. Debt in the Wall Street Journal.  The overall message is that international investors are getting nervous.

US 10 year yields are 2.9% already. German yields are 0.68%. Why aren't they buying our debt? Well, number one they are worrying a further slide in the dollar. Which comes when next year's international bond holders really don't want to hold US debt.

Most of the article is.. well, difficult for this former finance professor to follow. The article claims that one used to be able to lock in the difference, "Last year, buying Treasurys and swapping the proceeds back into euros provided European investors with a higher return than buying German sovereign bonds."[my emphasis] This sounds like arbitrage, "covered interest parity violations." That arbitrage is not perfect, but my impression is that it's not whole percentage points either. And you really can't lock in 10 years of funding. Besides which, someone else is on the risk-taking side of the swap. So the interviewed traders must be only partially hedging the difference. Perhaps it's really "uncovered interest parity," where you borrow Europe 0.68% invest in the US 2.9% and pray or only partially hedge the exchange rate risk. (On that, "The New Fama Puzzle by Matthieu Bussiere, Menzie D. Chinn, Laurent Ferrara, Jonas Heipertz, blog post at econbrowser documents that uncovered interest parity, where you invest in the high yield currency and take the risk, is losing its profitability. Interest spreads seem to correspond to future exchange rate changes after all.)

All to follow up on for another day. Mostly, it rang a bell as a little tremor that people who answer WSJ reporter's phone calls are expressing nervousness about US debt.

Again, these are little rumbles. I still think that a full blown crisis will come only amid a large international crisis, featuring some big country defaults (Italy?), big financial trouble in China, perhaps a war, state and local pension failures, and the US comes to markets with unresolved entitlements and asks for another $10 trillion. But I could be wrong. We live on an earthquake fault of debt, and the one thing I know from my own past forecasting ability (I have lived through 1987, the dot com boom and bust, 2008, the recent boom, and more, and saw none of them coming in real time) that I will not see it coming either.
John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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