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Weekend reading: The default drama is in the details

Weekend reading

Good reading from around the Web.

It’s taken over two years and more financial plot twists than you’d get in an episode of EastEnders: Canary Wharf edition, but I’m finally nervous about one of the economic dramas that so excites the world’s worrywarts.

I’m not too bothered about Europe. Despite claims such as those made by The Economist in my reading list below that the situation in Italy and Spain is the real threat, I have long shrugged my shoulders at the escalating crisis and uttered a Gallic “boff!”

Nobody should be surprised by what’s come to pass so far in Europe – it’s the inevitable result of monetary union without fiscal and political union – and Europe as a whole can meet its obligations. But doing so will entail the deeper integration long hankered for by Europe’s politicians but not its people, ushered in through the bond market’s back door. Sixty-odd years after the EU was set-up partly to contain its nationalistic ambitions, Germany will finally be at the heart of an integrated Europe. Whether she’ll be pleased is a different bowl of sauerkraut.

No, much more worrying is the complacency in the market about the threat of a systemic shock of some sort due to the farce unfolding in Washington.

Newspaper headlines are desperately trying to conjure up a ‘market in meltdown’ on these fears, but in fact, the markets haven’t moved much. In the epicenter of the potential quake, US government bond yields have actually dropped, meaning purchasers are judging them safer, not riskier – even as the chance of a downgrade to AA status or worse grows.

I can’t believe the US would be so insane as to default on its debts, but if it does then it will be tin hat time with nobs on.

Quoted by CNBC, Credit Suisse analyst Andrew Garthwaite finds that if no budget deal is struck but the U.S. does not default, each month of no rise in the debt ceiling could easily take 0.5-1 percent off GDP. He predicts equity markets would drop by 10-15%, prompting Congress to find a solution, and that bond yields would fall to 2.75%. Investors would in Garthwaite’s opinion need to get into defensive stocks, and out of the dollar.

But far worse would be an outright default:

That is where things could get nasty, according to the Credit Suisse team.

“This is very unlikely, but if it occurs, GDP could fall 5 percent plus, and equities by 30 percent,” Garthwaite said.

I think even this understates the dangers.

My concern is that the vast issuance of financial undertakings known as repos (repurchase agreements) that make the money markets go around are explicitly linked to the so-called risk-free rate, which is invariably AAA US government debt. A minor downgrade or default that might seem amusing to Republican revisionists could unwittingly set-off a massive chain reaction if it threatens the small print of these multi-trillion dollar obligations – a fear that is already causing some in the City to sit on their hands in a disturbing echo of the post-Lehman’s lock-up of 2008.

Hopefully there will be no US downgrade, and if there is then hopefully such small print will prove a technical sideshow.

However it’s the unforeseen dangers and the unintended consequences that tend to spark true financial routs.

I’ve no doubt ever-complacent bankers drew up their contracts believing a US default or downgrade was unthinkable. And that’s more than enough reason to be worried.

From the money and investing blogs

Mainstream money media

  • The West’s debt crisis: European edition – The Economist
  • Should BP split? – The Economist
  • Zoopla’s new house price heatmaps  – UK / London
  • Inside Match.com – FT
  • Five-year fixed mortgages falls to lowest-ever 3.39% – FT
  • Fund managers look to global brands – FT
  • Junior ISA limit raised to £3,600 – The Telegraph
  • Spooked savers stop new stock market investments – The Telegraph
  • Get rich slowly with global equity funds – The Independent
  • Joining a housing co-op to buy a London home – The Guardian

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{ 5 comments… add one }
  • 1 Salis Grano July 30, 2011, 4:02 pm

    >He predicts equity markets would drop by 10-15%, prompting Congress to find a solution, and that bond yields would fall to 2.75%.

    I am afraid that I find this a congenial scenario. I assume that if the US could not borrow more money owing to the deadlock, it would just print it.

  • 2 Brave New Life July 30, 2011, 4:19 pm

    I’ve been actively investing for 15 years, and I never pay attention to the market overall, just the stocks and funds I want to purchase. I don’t try to time anything.

    But this past week is the first week that I’ve started paying attention. It’s taking everything I have to leave my money where it is, stay calm, and take advantage of the FUD

  • 3 Faustus July 30, 2011, 6:03 pm

    I don’t see that there’s good reason to be as pessimistic as the Credit Suisse economist. The market has been robust in spite of all the scares this year from sovereign debt crises in Europe, poor growth in the US and the Japanese megatsnuami. The FTSE is still 10% up on a year ago (the US markets even more so) and it has been struggling to drop through the 5700 level. This suggests that buyers are taking opportunities on even very modest falls, and who can blame them given persistent high inflation and low bond yields. Short of an actual sovereign default it is difficult to envision that much downside.

    Like many others I’d welcome a decent correction and buying opportunity, but I’m not sure we should be holding our breath just yet.

  • 4 The Investor July 31, 2011, 9:46 am

    @Faustus — Imagine you have a contract saying X will do Y, with recourse to something linked to the AAA rated risk free rate. Now imagine that risk free rate is downgraded as a result of a perceived or actual default. Potentially that contract is now voided in some way.

    Consider that the repo market is near $10 trillion in size, and we have some idea of the potential scale of the potential disaster.

    This is something at least some City types are actively fretting over.

    If this market is forced to go to cash overnight then the credit markets will ground to a halt.

    Or perhaps they won’t. It’s a bit of a Y2K bug parallel… 😉

    Thanks for thoughts everyone, keep them coming!

  • 5 Bret @ Hope to Prosper July 31, 2011, 10:56 pm

    I have thought people were nuts to buy treasuries for years. This is not because of a potential default. It’s because the true rate of inflation is higher than the yield on treasuries. So, it’s a guranteed money loser. Unfortunately, the spending got so out of control, the government ran out of time to inflate its ways out of the debt. Hopefully, they will come up with a reasonable compromise to deal with the debt and spending, before the clock runs out.

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