Will the US national crisis follow the US banking crisis?
Chart of the week
The chart shows inflation from 1970 to 1984 (red) and inflation today (black).
Why this is important
You always read the phrase that past returns are not predictive of future returns. Yet, in uncertain times, investors look for similar situations to make a prediction.
The current period of a long period of low interest rates and then a sharp rise in inflation, last occurred in 1970, and the similarity of the curves is striking.
Under this scenario, we would see falling inflation until the end of 2024, when it would rise sharply again until 1928.
Such forecasts are important for anyone financing their home with mortgages. If a homeowner takes out a 5-year mortgage now, there is a risk that they will have to refinance in exactly the highest 2028.
Solvency of the USA
The USD is considered the undisputed world currency. A large part of global trade is conducted in USD. If there is a crisis in the world, investors flee to the USD. But now clouds are gathering.
The parliament in the USA sets a maximum debt limit in each case. If this is reached, the parliament must increase it so that the USA remains solvent. In 2011, the parliament refused to increase it the last time. The government had to send all civil servants into forced recess and pensions could only be paid with delay. Such a case is looming again.
Press statements from the U.S. Treasury indicate that the U.S. currently has 185 billion euros left before the debt ceiling is reached. Currently, the amount is falling by 10 billion per day. So in 19 days, the ceiling will be reached. That's how long the politicians have left to find a solution.
On Friday, they should have met the leaders of both parties in the U.S. with President Biden to discuss a solution. The meeting was canceled. The positions of the parties are still too far apart, he said. No new date was given.
The bank JP Morgan has made a survey among its customers whether they expect a settlement. 70% expect a last-minute solution, as has always been the case so far. But most of those surveyed expect there to be only a short-term solution, for example by the end of the year.
Now you could sit back and say "everything's fine". But it seems that investors are not so sure after all.
Investors can protect themselves against a total loss of bonds by taking out insurance. These insurance rights are traded on the stock exchange and are called credit default swaps (CDS).
The chart shows the price of insurance premiums for U.S. government bonds of different maturities. The premiums for a bond with 6 months to go have really exploded. The insurance premiums are now higher than those for the sovereign debt of Mexico, Greece or Brazil.
The chart shows the price of the insurance premium (CDS) for a U.S. government bond with a maturity of 5 years since 2008. Prices are approaching the levels seen during the great financial market crisis of 2007 to 2009,
Like all insurance, you have to read the fine print on CDS. The question is, when is a state insolvent and bankrupt. There are different terms for this.
"In a CDS contract, the protection seller makes payment when a credit event occurs. There are a number of events that can be defined as credit events. One such event is default, which can be a technical default or an actual default.
A default occurs when a counterparty defaults on its payment. A default is said to be technical if it is only a default and the debtor still intends to pay in a period of one to three months. Since the debtor intends to pay, this cannot be considered an actual default. A default is classified as an actual default only if it is actually in default and declares so. In such a case, the rating agencies also downgrade the debtor and change its rating to 'D'."
Source: Finance Train, 14.05.2023
In other words: If the U.S. government cannot pay for three months, it is only a technical default. Only if the situation lasts longer than three months is it a real default.
The chart shows the change in the yield curve over the past week. Just one week ago (blue), the interest rate for a US government bond with a maturity of one month was 4.5%. Now one week later (red), the interest rate is at 5.5%. Such a big change in such a short time is rare.
For the bonds with a longer maturity, the interest rate has changed only slightly. So it is not too late to sell longer-dated government bonds now.
The U.S. government has published a study showing the negative effect a U.S. default would have on the economy. A default of less than three months (short duration) would have only a small effect. If the default lasted longer (protracted default), the impact would be massive. The gross national product (GDP) could fall by over 6%.
Of course, these figures should be viewed with some caution. The current government, led by the Democrats, is currently interested in dramatizing the situation in order to force the Republicans to compromise.
So far, we have only talked about the US government bond markets. A default by the US would also affect the equity markets. The chart shows the return of the broad US stock market index from today and 2011, when the last government lock-down became a fact. Stock markets are likely to plunge as much as 10%. A possible currency loss, not included.
The chart shows that the U.S. government is also suffering from high interest rates, not just companies and citizens. The chart shows the monthly interest rates that the US has to pay on its national debt. These have almost doubled since the low in April 2021. In the current situation, this also severely limits the flexibility of the US government.
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