"Which is the greater threat – that the US goes over the fiscal cliff or that it does not?"

14 Nov 2012 by Jim Fickett.

Robert Jenkins, an external member of the Financial Policy Committee of the Bank of England, has an interesting essay in today's Financial Times with some thoughts on a possible US debt crisis down the road.

First he goes over some well-known points:

Each percentage point rise in interest rates adds (over time) $160bn to annual debt financing. Thus a 5 per cent rate rise adds $800bn to the budget deficit and, given compounding, more than $8tn per decade to the national debt. …

more than 45 per cent of tradable US debt is held by foreigners. The Japanese are in hock to the Japanese people. The US is in hock to – among others, the Japanese.

But then he gets into some more thought-provoking points that are less often discussed. The first is that, although US Treasury yields are now a fundamental benchmark in global finance, there is beginning to be some movement away from that.

globally, there are some $20tn of funded pension assets, $60tn of professionally-run assets under management and $600tn of various derivatives. The pricing of the related liabilities, expected returns and valuations is tied directly or indirectly to the yield on US Treasuries – all on the assumption that US paper represents a risk-free rate of return. Remove that assumption and we are in a financial world without gravity. …

sophisticated investors … are exploring two changes, each with profound implications for capital flows. First, they are asking leading investment firms to create a basket of securities that could replace the risk-free properties of US Treasuries of yore. Second, they are considering a shift from bond indices weighted by market capitalisation to benchmarks based on creditworthiness. The former favour US Treasuries, the latter may not. To the extent that these initiatives become trends, capital will flow away from those who borrow most and towards those who borrow least. Yields will reflect the change. Sounds familiar? Locals in Lisbon can advise.

The second is that QE has resulted in foreigners being more able to exit Treasuries than before:

By some estimates, the Federal Reserve now owns all but some $750bn of US debt issued with maturities of 10 years or greater. This suggests … that friendly foreigners have used the Fed’s market interventions to shorten the duration of their US holdings; and therefore that America’s creditors are less vulnerable than imagined to the threat of market losses – should they wish to exit.

And finally, regarding the title of this post, investors may be missing the more important issue regarding the so-called “fiscal cliff”:

The optimum solution would avoid undue belt tightening in the short term combined with credible deficit reduction in the longer term. Alas, a more likely outcome will involve some version of kicking the can further down a shortened piece of road. Here too, the old world holds lessons for the new. Indeed, faced with the prospects of postponement, the market may soon be asking a different question: which is the greater threat – that the US goes over the fiscal cliff or that it does not?