Ad Hoc Commentary – Yellen and US government ‘default’
As we have said before, Yellen will be the new Fed Chief:
The big issue on everyone’s mind is would the US government default. The short answer for external creditors is no. So China, Japan and the Middle East can rest assured for now. The short answer for domestic creditors is yes.
To understand this, we refer to Reinhart and Rogoff book: This Time Is Different. Even though that book had been embarrassed by some spreadsheet errors, it still contain many invaluable insights. As Reinhart and Rogoff noted on page 13:
“Usually, however, domestic debt crises do not involve powerful external creditors. Perhaps this may help explain why so many episodes go unnoticed in the mainstream business and financial press and why studies of such crises are underrepresented in the academic literature.”
It follows, since there is usually less publicity on domestic default, a sovereign would almost always default on the domestic obligations before giving up on the external obligations. We take a quick look at US government spending. The comprehensive one is here:
But a simple and old chart can be found at Wikipedia:
As you can see from the old Wikipedia chart, 23% went to Medicare/caid and 22% went to Social Security. Of course, these are pay as you go systems and it is technically a contingent liability and not an outright liability. But if we realize that the interest component of the outright liabilities is part of the budget, then we can essentially say that defaulting on welfare will help the American elites to keep the bond markets together.
However, pension and insurance fund managers will likely respond to broken contingent welfare promises. They will not sit idly by. In all likelihood, they would even be even more fearful that the Poland fate might befall them:
“…Poland intends to replace an outright liability (the bonds) with a contingent liability (the state-pension promise)…”
Despite the SPX selling off recently, yours truly is still in the view that there are really no alternative to dividend paying blue chips. So one just need to buy the dip. UST is a tough nut to crack. Short term, it is positive for UST because welfare is likely to be defaulted on. However, the medium term is still very bearish because confidence in that market is eroding. The USD is just a reflection of long term US yields, low US yields translates into weaker USD and vice versa. Thus, those selling the USD (especially against EUR) will eventually lose their shirts. We remember how the JPY and EUR first strengthened as they went into their sovereign debt crisis. The USD should be no different. The USD will be hero before it gets dismissed as mere pieces paper.
Good luck in the markets.