08.04.2011
By Terry Flanagan

U.S. Debt: A Drag For Creditors

Market participants across the board grow increasingly concerned about the United States deficit to GDP —traders, and portfolio managers alike.

Although Washington passed a historically high debt ceiling limit at north of 14 trillion on August 2, the agreement does little to assuage the debt itself, which is at a historical high and still growing.

Perhaps the most concerned are those that purchase U.S. debt, notably, Chinese sovereign wealth funds, who may ultimately want to distance themselves from the U.S.’s top export—treasuries.

“Traditionally, debtors had problems simply because they had limited buying power and that was their problem,” said Steve Shafer, chief investment officer of hedge fund Covenant Investors, based in Oklahoma City. “But when you have issues repaying the bank, and your debt is of a significant amount, that’s the bank’s problem.”

Roughly $4.45 trillion of U.S. debt is sitting with other countries, which is approximately 47 percent of U.S. public debt. The largest holders were the central banks of China, Japan, the United Kingdom and Brazil. In a few years, the share held by foreign governments has grown over time, rising from 25 percent of the public debt in 2007.

“This debt problem displays our inability to send strong confidence signals that we can handle our fiscal issues timely–not the 11th hour before the deadline to pass the debt ceiling limit,” said Shafer.”It’s something that China has recognized, but they can’t just move away so quickly and dramatically. It will happen behind the scenes.”

Expedited efforts to reduce exposure to U.S. debt, and decrease dependency on the dollar are key priorities for China, according to Shafer. “They’ll want to make the renminbi more convertible, tradable—more global,” said Shafer, highlighting China’s efforts to make their currency a standalone force. “They’re quietly losing their confidence in the U.S.”

If China ceases to be a U.S. benefactor, there is little that U.S. monetary policy can do to truly cure the deficit.

“I don’t know that the Fed or U.S. treasury will be credible to sell debt at realistic prices—it’s sort of similar to what Greece is trying to do now,” Shafer noted. ”We can’t really monetize the debt, and print more money, which is just kicking the can down the road—that would be catastrophic for the economy and the markets. It would push confidence even lower.”

Ultimately, Shafer commented that the U.S. will need to “pay for its consumption, and not just through credit. We need to take our medicine.”

Like other market participants, Shafer sees the recent debt ceiling limit legislation has a “paper tiger,” not possessing the “teeth that it needs to maintain confidence in front of our creditors.” Such dismissal of the agreement has rocked the markets—causing surges in volatility.

For Shafer, preparedness and risk management are good shields against volatility.

“We haven’t had to do anything different in the last wake of the discussion; we’ve been anticipating it,” he said. “We’re short treasuries and we’re not really net long equity exposure. We knew volatility was coming. Since 2009 and 2010, we’ve been prepared because it’s a boiling pot syndrome—an issue that creeps into our economic environment over several quarters—even years.”

Shafer projects that the greatest market volatility is still to come in the next six to 24 months, attributing such volatility to another major event tied to the debt crisis. “We’re going through seasons of complacency and calm, and then a boom will hit—the market response to the greater economic events will be non-linear.”

Perhaps the “storm” will be a downgrade of U.S. debt by one of the nation’s credit rating agencies—an assertion that Shafer acknowledges is a true possibility.

“We’re telling our clients that we’re expecting a downgrade before the 2012 election from a major rating agency,” Shafer said.

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