US Debt Ceiling Showdown: Price to Insure U.S. Government Debt Soars

Threats over an alleged US government shutdown, which has become the centerpiece focus of the debt ceiling debate, has sent cost of insuring debt higher this week

chart from Deutsche Bank

Notes the Wall Street Journal:

The cost of insuring against a U.S. default for a year has risen sixfold in the past week, reaching its highest level since 2011, reflecting investor bets that the government could fall behind on its debt payments in the coming weeks.

The Treasury Department said on Wednesday that by Oct. 17 it would have only $30 billion left to pay bills, and that money is only expected to last one or two more weeks unless Congress raises the so-called debt ceiling, which limits U.S. borrowing. Many Republicans have said they would approve such a move only in exchange for a long list of demands, such as changes to the White House's health-care law and lower tax rates. The White House has said it won't negotiate with Republicans at all and wants the debt ceiling raised immediately.

The stark political divisions have led many lawmakers, analysts and investors to wonder whether policy makers will be able to reach an agreement in time.

This has driven the annual cost to insure $10 million of U.S. government debt for one year using derivatives called credit-default swaps, or CDS, to €31,000 ($41,930), according to Markit data. That is up from about €5,000 as recently as last Friday and is the highest it has been since August 2011, the month in which U.S. debt was downgraded from the highest level by Standard & Poor's Ratings Services.

Default protection on U.S. Treasurys is quoted in euros, just as European sovereign CDS contracts are quoted in dollars, sparing investors the risk the hedge will fall in value at the same time as the currency itself.

Actions of the CDS markets have hardly been consistent with the bond markets.

As shown above, the 1 year (UST1Y) 3 year (UST3Y) and 6 months (UST6M) has recently been rallying (falling yields) mostly from the FED’s UNtaper—a deliberate tactic conducted by the FED similar to the Pearl Harbor surprise bombing equivalent of the bond vigilantes. 

This means that while cost of insuring of US debt has meaningfully risen, the treasury markets (particularly the short maturities) have been saying otherwise.

Yet rising CDS (default risks) will be used as political leverage to justify the call for raising the debt ceiling. (Have the CDS markets been stage managed?)

Americans have been deeply hooked on entitlements. More than 70% of Federal Spending has been due to dependency programs and growing.

This means that despite the hullabaloo in the US Congress, which really is just a vaudeville, as congress people will fear the wrath of losing political power and privileges from entitlement dependent-parasitical voters, eventually the debt ceiling will be raised. (charts from the Heritage Foundation).

Like actions of central banks led by the US Federal Reserve, America’s welfare state will be pushed to the brink of a crisis or will fall into a crisis first, before real reforms will be made.

In the world of politics, cost-benefit tradeoffs has been reduced to short term expediencies.

Updated to add: 

Including "housing, other loan guarantees, deposit insurance, actions taken by the Federal Reserve, and government trust funds”,  economist James Hamilton estimates at over $70 trillion or 6 times official debt (RT.com)

Meanwhile Boston University Laurence Kotlikoff has even far staggering figure. He pins the fiscal gap which includes unfunded liabilities at $222 trillion or 20 times bigger than official figures. 

Mr. Kotlikoff as quoted by Real Clear Policy: 

The official debt is something that has to be repaid, and the government is committed to principal and interest payments. But the government has other commitments, like Social Security payments, health care and Medicare payments, Medicaid payments, and defense expenditures. And it also has negative commitments, namely taxes. So you want to put everything on even footing. Most of the liabilities the government has incurred in the postwar period have been kept off the books because of the way we’ve labeled our receipts and payments. The government has gone out of its way to run up a Ponzi scheme and keep evidence of that off the books by using language to make it appear that we have a small debt.

Laurence Kotlikoff: The Scapegoating Of China

Author and Professor Laurence Kotlikoff argues, in a Bloomberg article, that the political heat applied to China, by certain political quarters, is not justified and represents the scapegoating of China.

Here is Mr. Kotlikoff,

Nothing could be further from the truth. But the truth is much harder to find these days than scapegoats. Fortunately, economics can move the debate beyond finger pointing.

Countries that run current account surpluses save more than they can fruitfully invest at home and invest the difference abroad. Countries with current account deficits do the opposite. They save less than their economy’s investment needs and attract investment from abroad.

Surplus countries take some of the seed corn they’ve saved and plant it in deficit countries. This physical movement of the seeds, or capital, is recorded as an export of the surplus country and an import by the deficit country.

Nations with current account surpluses are net exporters and have trade surpluses. Those with current account deficits are net importers and run trade deficits. Indeed, apart from the net income foreigners earn in the U.S. and invest here, their current account surplus equals their trade surplus, and their trade surplus is, apart from a minus sign, our trade deficit.

Again Mr. Kotlikoff shows how mercantilists have been selective in applying evidence to argue for their case..

So what ails the US?

Like Morgan Stanley’s Stephen Roach, Professor Kotlikoff refers to inadequate savings. Albeit with a different twist, savings that had been squandered from excessive redistribution programs from the US welfare state.

The key question is why we aren’t saving enough to fulfill our own investment needs. The answer is a decades-long fiscal policy that has been taking more resources from young savers and giving them to old spenders. This has driven our national savings rate down the tubes.

In 1965, Americans saved 14 percent of their national income. Last year the figure was negative 1.5 percent. What’s worse, our domestic investment rate -- the ratio of domestic investment to national income -- was only 1.8 percent.

Professor Kotlikoff asks for evidences to support the currency manipulation case.

Where’s the proof the yuan is undervalued? You won’t read studies claiming our real terms of trade with China are out of whack or find a black market in yuan. Instead, you’ll see studies that measure how much China would have to revalue to dramatically lower its current account surplus. But these studies ignore that such a revaluation would lower Chinese domestic prices for toasters, leaving the net cost of Chinese products to Americans unchanged.

Too many economists seem to disregard the basics of international trade when they equate China’s trade surplus with currency manipulation. One prominent economist recently described China as “engaged in currency manipulation on a scale unprecedented in world history.”

Let’s get a grip. China is a poor country. The fact that it holds some of its wealth in dollar-denominated assets is not proof of currency manipulation. Moreover, as China’s economy grows, the amount of its overseas investment will increase too. We need to get used to the Chinese investing in our country because that is tomorrow’s natural economic order.

So why the unwarranted fixation with currency fixes?

U.S. officials should also stop accusing the Chinese of manipulating their currency. Yes, China is pegging its currency to the dollar. But this isn’t evidence, per se, of currency manipulation. As a result of the 1944 Bretton Woods agreement, the U.S. spent decades fixing its currency to those of other nations. No one accused it of unfair trade practices.

A fixed exchange rate is fully compatible with free trade because the dollar price Chinese exporters charge for their goods is the result of two things: the exchange rate and the cost, in yuan, to produce the good.

Getting the Chinese to make their currency more expensive (forcing us to pay more dollars for one yuan) won’t make Chinese exports more expensive to American consumers since the internal cost in China of producing these products will fall. The Chinese restrict their supply of yuan to make the currency appreciate relative to the U.S. dollar. When fewer yuan circulate in China, prices there fall.

As we long and repeatedly argued, the accusations of China as currency manipulator signifies as a diversion from the real culprit to the loss of US competitiveness: inflationary policies.

And the scapegoating of the China, similar to the Japan episode in the 80s, signifies as the entitlement outlook parlayed into free lunch policies.

At the end of the day, it’s never about economic reality but about political propaganda that benefits the elite minority.