US debt drama haunts ‘risk free’ assets

October 18, 2013 4:56 pm

US debt drama haunts ‘risk free’ assets

By Ralph Atkins in London

The world has this week admitted the possibility of two things previously thought impossible. First, yetis could exist: the mythical mountain beast might be a polar bear hybrid, according to a British scientist. Second, the US could default on its debt. While Washington prevented the October 17 US debt ceiling deadline leading to catastrophic payment glitches, the uncertainty caused by the political showdown has raised fears about the country’s growth prospects and its global economic influence.But other repercussions could haunt markets like yetis. The doubt cast on the ultimate safety of US debt hit the working of US financial systems – in short-term interbank loan markets, for instance.

“I think it has opened people’s eyes up. We need ‘safe assets’ in the global financial system,” says Manmohan Singh, a collateral expert at the International Monetary Fund. “US Treasuries are safe assets. You could say German Bunds are safer but the size of the market is not the same and they are not denominated in the world’s principal reserve currency.”

The idea of US debt as a virtually risk-free asset underpins global finance: US bonds are used to price dollar-denominated issuance globally. Movements in other bond prices – Bunds, for instance – are strongly correlated.

What difference this week’s events will make depends on whether “safe” is an absolute concept, or a relative one, argues Mohamed El-Erian, chief executive of Pimco. “Until recently, there was no need to ask this question because the US was seen as triple A virtually across the board.” Fitch, the credit rating agency this week put the US on “negative watch”, a step towards possibly removing its triple A status. Standard & Poor’s downgraded the US in August 2011.

But that did not mean US debt has become less safe compared with possible alternative longer-term investments. “There is no doubt that the ‘relative’ criterion is still being met as the US Treasury market remains the deepest and most liquid financial market – and that the dollar is the global reserve currency,” says Mr El-Erian.

Laurence Mutkin, global head of rates strategy at BNP Paribas, adds: “If yetis exist, what difference does it make to the world’s financial centres? You’re still probably not going to see one.”

Unlike with corporate bonds, US Treasuries do not have clauses where failure to service one issue triggers default on others, and there was no obvious alternative for nervous investors. “If there had been a default on a short-dated US bond, there would have been a flight to safety into longer-dated US bonds,” says Hans Lorenzen, credit strategist at Citigroup.

“It was a self-imposed debt ceiling,” says Iain Stealey, senior bond portfolio manager at JPMorgan Asset Management. “I am sceptical that we have discovered the possibility of a US default.”

But the week’s events may change the way the US is viewed globally. “What we have learnt is that the US is in a similar situation to Europe, where nothing happens without a crisis first. That increases the risk of policy errors,” says Robert Farago, head of asset allocation at Schroders private bank. For central banks managing their reserves, the Washington showdown “ought to strengthen the argument that they are too concentrated in US Treasuries,” says Mr Lorenzen.

It has also added uncertainty and reinforced lessons learnt during the global economic crises of the past six years about previously unimaginable events, says Julian Callow, international economist at Barclays. “We don’t know a lot about things we take for granted. We can still operate, but we now know that the world is a lot less certain . . . It is quantum physics not Newtonian physics.”

Moreover, for some short-term financial market transactions secured against collateral such as US Treasuries, their “absolute” safety is critical. Treasury bills with a short shelf life are used extensively as collateral by banks and investors trading futures, derivatives and for short term loans in the repurchase, or “repo” market, which provides essential funding for much of the financial system.

The possibility that the US Treasury might delay payment on bills expiring in October and November unnerved money funds this week: Fidelity said it had sold holdings of bonds maturing towards the end of this month. In turn, Hong Kong applied a higher “haircut” – or discount – on bills used as collateral, helping push one-month yields above 60 basis points. In the repo market, traders reported banks had stopped using October and November bills as collateral.

A widespread assumption, however, was that in an emergency US authorities would have acted to prevent serious mayhem. It did not go unnoticed that the New York Fed had rushed into operation in late September a “reverse repo” facility which lends out Treasuries against cash, ostensibly to help monetary policy makers control short term interest rates.

“Was it a function of October 17? I don’t know but it is a way of providing safe assets, of ensuring good collateral is available,” says Mr Singh at the IMF.

And even in short term Treasury bill markets, this week’s sell-off was still modest – nothing like as great as if default had a serious possibility. Spotting a Himalayan monster still seemed more likely.