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How will Deficit Squabbling Impact Treasuries?

Nov 23, 2011
Ron DeLegge

Disagreements over the debt ceiling and how to cut federal deficits by $1.2 trillion over the next ten years have created their fair share of uncertainty. What lies ahead for U.S. Treasuries?

Dreaming up a deficit reduction commission was the easy part. Unfortunately, nobody thought getting committee members to agree would be the hard part.

How will the deficit impasse affect U.S. Treasury prices? Are higher bond yields just ahead? And what about the U.S. government’s credit rating?

Agreeing to Disagree
After two months of intense negotiations, talks between 12-member “super committee” broke down on Monday. The committee (now known as just the “stupid committee”) is an even split between Democrats and Republicans and they agreed to disagree, which means $1.2 trillion in automatic spending cuts which begin in 2013 are triggered. What’s so bad about that? Automatic spending cuts are good for the deficit, but only if Congress doesn’t try to undo them.

Meanwhile, Treasury prices continue their upward march, despite all of the doom and gloom proclamations. Since the beginning of the year, long-term U.S. Treasuries (NYSEArca: TLT) are ahead by more than 33% and by 10.32% over the past three months alone. Even during the mid-year debt ceiling debacle, ETFguide took a contrarian view and kept its bullish view of Treasuries, in contrast to many of Wall Street’s pundits, including PIMCO’s (Nasdaq: PTTAX) every outspoken Bill Gross. But what about now?

A Credit Rating for the Ages
I rank Warren Buffett’s declaration that the U.S. government deserves to have a quadruple A-rating as the most foolish financial utterance made this year – and that’s saying something, because the year isn’t yet over. Credit ratings have been wrong in the past, they’re still wrong today, and they’ll be wrong again in the future. Buffett probably knows this, but as a shareholder in Moody’s (NYSE: MCO), he’s got financial interests to protect. Parents protect their ill-mannered children all the time, so in this regard, Buffett is no different.

The general translation is this: Taking long or short positions in Treasuries (NYSEArca: IEF), or anything else for that matter, based upon the credit opinions of the three musketeers (Fitch Ratings, Moody’s and Standard & Poor’s) is a dumb strategy. This is especially true in the world of “high finance” where many institutional investors and pension funds still accept credit ratings as gospel. 

The fact is credit raters are unreliable, at times incompetent, and at other times utterly shameful. And the mistaken downgrade of France’s AAA-credit rating by Standard & Poor’s (NYSE: MHP) is a perfect example of all three. Investigators are still searching for an answer to how such a magnificent blunder of this sort could occur. For lack of a better explanation, I’m just calling it a “wardrobe malfunction.”

Cheering for Higher Taxes
What will it take to reduce the deficit and what will it mean for Treasuries? The pitiful truth is that spending cuts alone will not be enough to significantly reduce the nation’s $14 trillion debt load. Put another way, higher taxes are a certainty.

Yet, the reality of higher future taxes is something few Congressional members will admit. It’s easier to kick the can down the road and let another President or another administration deal with it, rather than to face the truth.

Alan Simpson, a Republican who served as co-chairman of President Barack Obama's deficit committee last year along with fellow deficit committee co-chairman Erskine Bowles have gone on a national tour explaining to crowds or ordinary Americans that solving the nation’s debt problem requires a combination of spending cuts and tax hikes. How have crowds responded? According to Simpson, he’s received standing ovations regardless of the people’s political leanings. It remains to be seen whether the standing ovations will continue, when and if, higher taxes become a reality.

In the end, taxation is based purely upon supply and demand. The people supply more tax revenue whenever the government demands.

Don’t Bet Against History
On July 27, just ahead of the August debt ceiling deadline here’s what ETFguide’s Weekly ETF picks said:

“Our first recommendation is to ignore the noise being spread by major media establishments. No matter how much their headlines make it seem that a deal will not get done, the historical odds show the exact opposite. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit. And while losing the coveted AAA-rating is bad, it isn't a total disaster. Even with a downgrade, U.S. debt would still be considered ‘investment grade,’ so by that standard, bond funds and ETFs linked to major indexes would still hold U.S. paper.”

Throughout the debt limit debacle, ETFguide continued to hold U.S. Treasuries in its Ready-to-Go ETF Portfolios and it warned subscribers to "not bet against history." 

Conclusion
Today, the future movement of U.S. Treasuries is already being shaped. And again, the crowd and its conventional wisdom will be proven wrong. Why are traditional credit models, including analysis of bonds (NYSEArca: AGG) still broken? Because the fancy quant models can’t quantify Washington D.C.’s folly. 

ETFguide’s latest analysis of Treasuries in its Weekly ETF Picks looks at long-term Treasuries and outlines three key catalysts for this market. It highlights technical levels for Treasuries and a way for ETF investors to capitalize.

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