A Few More Words From London

A Few More Words From London
July 16, 2011
David Kotok


In Friday’s FT, James Mackintosh illustrated a critical difference between Europe and the United States. He noted that the Italian debt auction had an interest rate of 4.93% on 5-year government debt. That was a full percentage point higher than last month. He contrasted the Italian auction with the US auction of $5 billion of 2-week debt at an interest rate of zero. As Mackintosh said, with great politeness, “The fundamentals of the two countries do not justify either the optimism over the US, or the pessimism about Italy.”

This is not about optimism or pessimism. This is about the construction that Mackintosh outlined in his column. In Italy, the European Central Bank cannot directly buy government debt. Therefore it can only support Italy through conduits and only in minimal amounts. The conduits are the same banks in the same banking system that are under “stress” because of stress tests and that are dealing with a mix of sovereign debt in Europe that is highly suspect in terms of its creditworthiness.

In the US, the debt markets have the support of the Federal Reserve. The US gets away with its approach because its central bank has a policy that retains an interest rate at zero. Meanwhile, the Italians do not have the ability to use this approach, because their construction with the European Central Bank has taken away the weapon of maintaining their own sovereign debt in their own currency. In the old days, when the Italians used lira, they too had the ability to directly finance themselves.

The victims of the policy difference are the investors, the bond holders, and all those tied to them. Think about this as trillions of dollars around the world, impacting nearly all the elements of finance and government that we can imagine.

If you contrast the two interest rates, you find some remarkable comparisons, which Mackintosh has summarized in his columns. He writes that “the Italian government should have a surplus before interest” due to its new budget austerity. Meanwhile, the US is expected to run a deficit of 9% of GDP, before interest, this year.

We digress again. Note the difference between Italy responding to the impact of higher interest rates and changing its political mechanism, with political adversaries coming together out of a national interest. Contrast that with the United States and the behavior of the Democrats and the Republicans, which we would rate as poor, impoverished, irresponsible, and foolish. We too are being polite.

If Italy could borrow at US rates, then Mackintosh calculates that Italy “would look [to] have a budget deficit of just 2 per cent,” and therefore be “more like Germany than Greece.”

If the United States had to pay the interest rates the Italians have to pay, the US would face a game changer, in our view.

The point is: if you look at current interest rates, the world today is upside down and backwards.

Rating agencies only exacerbate the problem. In Europe, they have made such a mess of their ability to forecast creditworthiness that the Europeans are now ignoring the ratings and talking about ways they can create their own rating agencies because of the failure of the ones they used to rely upon.

In the US, the rating agencies now threaten to remove the AAA status of the United States. This is no insignificant issue. The AAA status of the US is the premier credit assessment in the world. It is being diminished, emasculated, and corrupted by American politics. The warnings are very clear by the rating agencies and the central bank leadership. The behavior in Washington is extraordinarily threatening.

A final word of warning: Americans currently are enjoying very low interest rates. At the short end of the yield curve the interest rate is effectively zero. At the longest end of the curve, the 30-year Treasury bond yields somewhere in the low 4% area. The Federal Reserve has practiced a policy to bring those interest rates to that level and keep them there. The Federal Reserve will not be able to control those rates if the world views the AAA creditworthiness of the United States as jeopardized. We saw that in the very short-term reaction in debt markets over the last few days, when there was the first inkling that the debt-ceiling issues will not be resolved in Washington.

The more politicians play brinksmanship, the more they threaten every retirement plan, every beneficiary of a payment stream from the US government, every investor, and every citizen in our country and elsewhere in the world who depends on the creditworthiness of the United States.

Cumberland’s position is based on an assumption that the United States of America will not default. We believe politics will play brinksmanship to the very end and subsequently extend the debt ceiling. The politicians have already introduced cost. There is already a risk premium in the market.

The fundamental assumption is that the US has the capacity to pay, as it has the structure with the Federal Reserve to achieve the liquidity, and in the very end, it will pay its debt and bills in a timely way. Based on that position, we are still fully invested in equity markets around the world and are maintaining our bond positions. That being said, the events suggest to us that a meaningful change in attitude and a permanent cure are not developing in Washington. In Washington, things are done for immediate political expediency, vision is limited to the next election, and the sense of responsibility is deteriorating to a new lower and abysmal level.

Therefore, at Cumberland we will commence a gradual process of shortening duration in bond portfolios. We do not see this as an immediate necessity. We do see it as a strategic shift. Policies that were responding to financial crisis are now running amuck. Our portfolio change will be gradual. When government policies explode in negative outcomes, they are usually received as surprises by markets. A touch of defensiveness is now warranted.

We are heading for Heathrow Terminal 5 tonight. We will be back at our desks on Monday.


David R. Kotok, Chairman and Chief Investment Officer

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