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Interest rates often do not warn of default risk [ClearOnMoney]
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Interest rates often do not warn of default risk

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Commentary

Interest rates often do not warn of default risk

20 Apr 2011 by Jim Fickett (removed dead link 5 Feb 2013).

Despite assurances from Washington, low interest rates on long-term Treasuries do not indicate a low likelihood of default. Some sort of default, direct or indirect, is likely in the medium-to-long term. Although there are some possible warning signs (another credit boom, or recession, for example), one good strategic direction is to move gradually towards an inflation-resistant portfolio.

Yesterday Catherine Rampell at the NY Times had a blog post entitled Should you worry about a U.S. default? Rampell does not answer the question in her title, instead mainly saying that neither S&P's lowered outlook, nor Tim Geithner's reassurances afterwards, tell us very much. Her closing sentence is,

Unfortunately, despite what you may have read lately and seen in the markets, sovereign credit ratings and current interest rates may not actually lend you that much insight.

In many situations, not just for sovereigns, it seems that interest rates on long-term obligations, which should be pricing in future risk, are very bad at doing so.

Here is a graph I presented earlier, showing that during the great inflation the yield on the 10-year Treasury bond rose and fell along with, or after, inflation, rather than in anticipation.

And here is a record of the high-yield spread over Treasuries (via the IMF's Global Financial Stability Report), showing that in the summer of 2007, when there was already abundant evidence of major problems in the credit markets, junk spreads were still at or near record lows.

Rampell suggests, based on work by Carmen Reinhart, the same lack of look-ahead is true for a sovereign debt crisis:

In other research Professor Reinhart has found that that interest rates are surprisingly bad at predicting debt crises in the near future. The painful rise in the cost of borrowing that is typical in a sovereign debt crisis often comes on extremely suddenly, Professor Reinhart says.

Rampell here links to a paper by Graciela Kaminsky and Carmen Reinhart, entitled The Twin Crises: The Causes of Banking and Balance-of-Payments Problems. This paper is not directly applicable to the US, as it studies banking and currency crises in “small open economies, with a fixed exchange rate, crawling peg, or band”. In those cases, at least, interest rates failed to provide the signal you might hope for before currency collapse.

Coming back to the title of this post, the general conclusion on interest rates is that when they rise, it may be already very late in the game. This is fundamental to the cyclical nature of the credit markets – as long as bond prices are rising and times are good, everyone wants in and yields continue to fall. Then when yields start to rise, everyone rushes for the exits.

Returning to Rampell's question, the question, and answer, come in two parts.

First, is default (either through direct bond defaults, or indirectly, through inflation) a possibility that reasonable people should worry about? Absolutely. And, to the extent that Kaminsky and Reinhart's conclusions might apply to the US, the most important point is that an over-leveraged and under-regulated banking sector greatly increases both the risk of a sovereign debt crisis and the severity of the crisis when it comes. The fact that most of the new regulation is without much bite, and that the too-big-to-fail problem is worse than ever, suggest considerable danger.

Second, what warning signs might we see? Again assuming that Kaminsky and Reinhart might be relevant to economies outside the scope of their database, there might be two warnings. The first is a credit boom:

The growth in domestic credit/GDP remains above normal as the balance-of-payments crisis nears but particularly accelerating markedly as the twin crises [sovereign+bank] approaches; throughout this period it remains well above the growth rates recorded for tranquil periods, consistent with a credit boom (and bust) story.

And the second is recession.

For balance-of-payments crises, the 12-month growth in output bounces in a range of 2 to 6 percent below the comparable growth rates during tranquil periods—with a tendency for the recession to deepen as the crisis nears.

Together these suggest a natural enough scenario: another credit boom (occurring even now in some areas), followed by bad loans surfacing and a recession beginning, then another government rescue and, as investors realize that another bank bailout will cause an already-high deficit to worsen, a bond market revolt.

All in all, though, I do not think it will be easy to predict the timing of any default. It is better, therefore, to take precautions ahead of time. In my view one should use the next few years to understand well what assets best preserve capital during a major inflationary period, and to move into those assets as opportunities arise. Such a portfolio shift takes a long time, if you want to sell high and buy low, and so should be a priority long in advance of any clear signs of default.