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Downgrading the US "Parasite"

The consequences of a US sovereign downgrade...

THE DEBT CEILING deal is a big fat nothing. A bad joke. It raises the US debt ceiling by $2.1 trillion over the next two years—enough to get us through the next Presidential election. The $2.4 trillion in spending cuts and "savings", meanwhile, are to be phased in over 10 years, writes Dan Denning in his Daily Reckoning Australia.

Ten years is plenty of time for Congress to find ways around spending cuts. The net result of the deal is that the US will have around $17 trillion in debt in a few short years. You can bet your worthless Dollar on that. Defense spending will be cut, which is a good start. But spending on entitlements like Medicare, Medicaid, and Social Security won't be touched.

In short, the United States remains a nation that refuses to live within its means. Its political leadership is either economically illiterate, in denial, spineless, or some combination of all three. This deal makes it a virtual certainty that the credit ratings agencies will downgrade US sovereign debt. And that's when the global fireworks will start going off. 

What will happen when the US government is downgraded by the ratings agencies? Well, that's the multi-trillion-Dollar question, isn't it? There are many pension funds, mutual funds, sovereign wealth funds, and probably Australian super funds and local councils that have exposure to US debt. By law, some of those who own US debt will be forced to sell it if it no longer has a triple-A rating.

If you're a forced seller of US government debt, and you owned it because you thought it was a safe, sound, long-term repository for your cash, what would you buy instead? Used cars? Used gold? Other government's bonds?

Here in Australia we're watching the action in Aussie government bonds. The volume on credit default swaps related to the Aussie sovereign debt has been on the up. Betting on an Aussie government default has become a bit of proxy bet on Australia's banks. The logic of the trade is that if the housing market blows up, a crisis in any one of the Big Four banks will force the Aussie government to use its triple-A credit rating to bail them out.

That's an interesting trade. It's consistent with what's happened in other countries where the housing markets have blown up and taken the banking sectors with them. That forced the government to assume the liabilities of the banks, which in turn put enormous pressure on government finances, driving up the cost of insuring against default, and increasing the probability of default.

Data provider CMA uses credit default swap prices to construct what it calls a cumulative probability of default on corporate and government debt (CPD). Its most recent data suggest there's a 76% chance of Greece defaulting on its government debt within the next five years. For Portugal it's 55%. And for Ireland it's 50%.

Even after the debt ceiling brouhaha in the US, the CDP is just 4.26%. That's actually lower than the most recent Australian CPD figure of 5%. You might wonder how it's possible that a nation with over $14 trillion in fiscal debt that's nearly 100% of GDP and growing can have a lower probability of defaulting than a nation that appears to be in much better fiscal shape.

Either the bond markets are dead wrong, or they're telling you that at a systemic level, Australia's government faces the same risks as the US government — bearing the burden for a bust in the credit (especially housing) markets. There are two differences. One, Australia's housing bubble hasn't burst yet. And two, Australia does not print the world's reserve currency.

The US can print the same money it borrows in. It doesn't ever have to default as long as it retains this privilege. But its creditors now know that the US can't be trusted. This is why America's trusted friend and car pool partner in space, Vladimir Putin, has said Americans, "Are living like parasites off the global economy and their monopoly of the Dollar."

Them used to be fightin' words. But now they are just words that confirm that we have come the end of the Dollar's reign as the world's reserve currency. This should push up yields on government bonds. And in the long run, it will push up the price of precious metals too, as a reserve monetary asset (money).

What it will do to stocks is not quite as clear. But our prediction is that you'll see a whole lot of sideways action. Without additional liquidity surges to push indexes higher, and with manufacturing activity across the world showing a slowing economy, stocks are facing a double whammy.

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Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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