Congress Bickers, Bond Markets Brace for Panic: William D. Cohan
Hold on for just a New York minute now and consider the powerfully serious message the bond market sent last week about the political dithering in Washington and in Europe’s capitals. “Pay attention folks,” as the investor Gifford Combs e-mailed me on Friday. “This is not a drill.”
Here are the facts: The yield on Greek sovereign debt is now at record highs for the euro era. Last week’s state-managed bond auction in Italy almost failed. And, while few seem to have noticed, the overnight repurchase market -- for short-term, secured, corporate debt obligations -- nearly seized up amid what Combs described as “an almost panicky scramble” for less- risky paper.
Indeed, investors’ manic desire for safety last week reached levels not seen since the most acute days of the financial crisis in September and October 2008. Ironically, though, given the pathetic display in Washington and the country’s ongoing fiscal troubles, people turned in droves to the perceived security of the U.S. Treasury market, even though it has never looked shakier.
Remember the days of negative yields on short-term U.S. paper -- when effectively investors paid the government to keep their money safe? Warren Buffett considered that happenstance so rare that two years ago at the Berkshire Hathaway Inc. annual meeting he flashed a slide of a Treasury sale transaction ticket to his legion of followers.
Negative Yields Return
Well, it seems those days are back. U.S. Treasury bills shorter than three months in duration traded at negative yields last week. Three-month bills were trading a yield of 1 basis point. Six-month bills traded to yield 4 basis points and one- year U.S. Treasuries were trading to yield 13 basis points.
In short, demand for the perceived security of the debt obligations of the U.S. government was so intense that “it was virtually impossible to find ANY amount of certain maturities of short duration Treasury bills,” Combs informed me. He ended up buying what he could of the one-year notes and paying big time for the privilege (resulting in that minuscule 13 basis-point yield).
Not everyone, however, seems to have so much faith in the U.S. The Saudis appear to be so concerned that Congress and President Barack Obama will not be able to reach a resolution on increasing the debt-ceiling by Aug. 2 -- pushing the Treasury to possible default on the nation’s obligations for the first time -- that, according to market insiders, last week they Hoovered up euros as a possible hedge. This helps to explain why the European currency has managed to more than hold its own against the dollar despite the continent’s economic woes.
At the same time, it’s an open secret on Wall Street that the Federal Reserve Bank of New York has become increasingly concerned about the state of U.S. money-market funds. With as little fanfare as possible -- understandably, so as not to cause a panic -- the New York Fed has been urging domestic money- market funds to reduce their exposure to European banks, where the funds have turned to increase yields not available in the U.S. because of rock-bottom interest rates.
The Fed is said to be terribly worried that -- because of provisions in the Dodd-Frank law -- it will no longer be able to rescue a money-market fund if it “breaks the buck,” as the Fed did famously the day after Lehman Brothers Holdings Inc. filed for bankruptcy.
Threat of Downgrades
As if all this were not enough, last week both Moody’s and Standard & Poor’s put the U.S. itself on credit watch, with negative implications about a possible downgrade. S&P said that while it expected an agreement regarding the debt ceiling, it was worried that the country’s fiscal house will remain in disarray.
“Despite months of negotiations, the two sides remain at odds on fundamental fiscal policy issues,” it stated in its Bastille Day note. “Consequently, we believe there is an increasing risk of a substantial policy stalemate enduring beyond any near-term agreement to raise the debt ceiling.”
Additionally, on Friday, S&P put the six AAA-rated insurers -- including New York Life Insurance Co. and Northwestern Mutual Life Insurance Co. -- on the watch list for a possible downgrade because of their significant holdings of U.S. Treasury and agency securities. None of this is even remotely good news.
Charade in Washington
What is the bond market telling us? Combs, a founder of Dalton Investments LLC in Los Angeles, likens the panic in the bond market to the unambiguous message the stock market sent on Sept. 29, 2008 -- when the Dow Jones Industrial Average dropped 780 points, the largest one-day point drop ever -- after Congress voted down the first version of the TARP bill. That’s how concerned the bond market is now about the charade going on in Washington.
Combs worries, though, because of how inherently more difficult it is for people to understand the machinations of the bond market than those of the stock market, that the message this time is not getting through to the politicians in Washington, who seem intent on taking a nonchalant approach to the potential Aug. 2 deadline for raising the debt ceiling. (Some politicians -- hello, Michele Bachmann -- have actually claimed that defaulting on our obligations would be good for the country.)
Politicians Don’t Understand
His concern is that politicians don’t understand how intimately tied transactions are on a worldwide basis to U.S. Treasury securities, and that if Treasuries were no longer accepted as collateral, the resulting market turmoil would make the “collapse of Lehman Brothers look like a walk in the park.”
Combs said he believes a default on U.S. Treasuries would set off “an unholy scramble” for what constitutes “good and valid” collateral, creating a huge problem in the worldwide payments system: “It’s a situation no one has ever faced before -- that people stop accepting Treasury bills as collateral.”
Even though, incredibly, the politicians in Washington took the weekend off from their negotiations, a bunch of them still found the time to appear on the Sunday morning political talk shows to make the case that a compromise will be found before Aug. 2. We’ll see if they are correct -- but bond traders are going to be increasingly less likely to bet on it.
(William D. Cohan, a former investment banker and the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. The opinions expressed are his own.)
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