Inflection Point has arrived
We have known that we have been due for a change in the markets for some time. We may ascribe some weights to the many different factors that are providing the critical catalysts for the change. The factors are not easily put on an ordinal scale. All of them have importance.
Last week we would have said that the clear signal that the tapering would commence that was provided by Fed Chair Powell was the main contributor. This week I would say that the primary concern is the consideration of the debt ceiling. There is also the federal budget, the infrastructure bill, and the social infrastructure bill foremost in mind. At this point, there are serious doubts about whether anything may be accomplished on a bipartisan basis at all despite the general consensus that is present on the infrastructure bill. The Rule of 51 will probably be invoked once again.
Even a potential default of the United States is not to be taken lightly. I must view this potential event through my experiences at a major rating agency and at a prominent broker dealer.
If we consult the rating definition of a AAA bond one must conclude that the probability of a default is extremely remote. Just the fact that such a circumstance is being discussed seriously calls into question the AAA designation. Of course, there is the technical risk and the political risk to evaluate.
Concerning the former, the Treasury Secretary Janet Yellen informs us that with extraordinary measures the integrity of the cash flow may only hold up until October 18. This date is becoming much too close for comfort. Whether you agree that there should be a debt ceiling or not is simply not relevant at this critical juncture. The potential crisis is upon us.
The political risk in this case is front and center. Even for those who do not follow all the twists and turns of the policy debates, an aware citizen has an appreciation for the gravity of the circumstances. In this case, the political is more perilous than most of the other factors.
I recall being in the room at a rating agency in the 1970’s early in my career when we had stagflation and incredibly high interest rates before Fed Chair Volcker took restorative action. Those of us in the room debated whether the USA was still a AAA credit. The national debt levels were very different and much lower as a percentage of GDP at the time. There was a lively debate about the appropriate course of action. The rating was maintained at the time, but part of the rationale was due to exceptional liquidity and market access to the debt market. Despite all the pressing negative factors, the greenback remained the reserve currency for the world.
Political risk has been more of an important topic when parsing other sovereign credits around the globe. Unstable governments do not inspire as much confidence when it comes to the matter of paying debt. The prospect of having to do a restructuring at some juncture looms more as a real possibility. Do you recall the Brady bonds for those of us who have been around for some time? That program was challenging to conceive and to bring to fruition.
As an American, I always like to think that we lead by example when it comes to taking responsible actions especially in the financial world. Even the mere suggestion of the possibility of defaulting is navigating a very tricky path.
For those of you who think that such an event may not impact states and localities debt, think more. We used to talk a lot about the sovereign ceiling and how a state or local credit could not be rated higher than the sovereign rating. We have had this consideration since S&P downgraded the USA in 2011. That action has not caused too many challenges at the state and local level in part because there are so few AAA rated state and localities today relatively speaking. But, if another rating agency were to lower its rating to the AA category, the implications may be much harder to put aside. The municipal market would be poised for a potential cheapening. However, if demand remains so strong from investors the effect may be muted. For those seeking safety and stability, the Treasury market and the municipal market would remain among the most creditworthy.
It remains to be seen whether such an event would bolster the argument for the Chinese currency to become a primary reserve currency. This outcome is not probable in the short run but in the longer run may become more of a consideration.
In the end, this entire discussion stands a very good chance of becoming a moot point because Congress will take the appropriate action to avoid the meltdown. Yet, each time we approach the precipice we discover new meaning in the points to be made. The takeaway for the municipal market continues to be to heed the possible cliff risk.
We always speak of the ability and willingness to pay debt. The latter is being questioned more and is often the more critical factor than ever before.
John Hallacy
John Hallacy Consulting LLC
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