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May 2011- U.S. Default: In the News

U.S. Treasury securities have long been regarded as the best proxy for a theoretical risk-free asset. Their payments are backed by Congress’s unique power to tax an economy that accounts for a quarter of the world’s entire economic output. But this risk-free reputation is now in question; as U.S. gross debt approaches 98 percent of GDP the phrases “U.S. default” and “price inflation” have become pervasive in the media.

How then, is the U.S. government still able to borrow at historically low interest rates? Ten year Treasuries are currently yielding only 3.1 percent. Treasury bond prices (and yields), like those of any capital asset, are affected by news of all kinds. But when Treasuries’ greatest selling point, their creditworthiness, is in question, it is hard to divine any offsetting “good” news that would explain a rate of return suggesting such low risk.

Perhaps this is because investors live in a world of alternatives and many other sovereign lenders are in similar straits. Despite its fiscal woes, the U.S. is still regarded, apparently, as “the world’s tallest dwarf” among issuers of fiatbacked debt.

There are signs this could be changing. The price of credit default swaps (CDS) for short-term U.S. Treasuries tripled over the six days ending May 25 as political rhetoric grew heated regarding an increase in the government’s $14.3 trillion debt limit. CDS insure against lender default.

We do not weigh in on politics, other than to assess matters in terms of the incentives faced by politicians. Republicans will allow an increase in the limit only if meaningful spending reforms are adopted; they hope to appeal to a growing sense of anxiety among voters regarding government debt. Democrats are banking on an aging electorate fearful of spending changes, particularly those that might threaten entitlements.

If the debt limit is not increased, is unclear how the bond markets will respond. Renowned bond investor Peter Druckenmiller has argued persuasively that exceeding the debt limit (technical default) might be tolerable to bondholders.

Also In This Issue

Information And Market Prices
Markets Don’t Have To Be Right To Be Efficient
Peace Amidst The Tempest
ETFs: The Nuts And Bolts
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow Jones Industrials Ranked By Yield
Recommended Investment Vehicles