The Trillion Dollar Coin would be bullish for Treasurys
I just wanted to follow up on Randy Wray’s last post to look at this Trillion Dollar Coin idea from an investing perspective. I believe the coin would be bullish for Treasuries because it lowers average Treasury duration and alters private portfolio preferences in a manner similar to quantitative easing. Otherwise, it has no real economy effects.
We discussed similar mechanics in 2010 regarding QE2 when Randy wrote his post about QE2 being the equivalent of issuing Treasury Bills. In that case, the Federal Reserve was buying longer duration US government bonds, making them relatively more scarce for bond market investors. The result was that average duration for all Treasurys outstanding was shortened. Moreover, to the degree investors had a duration preference as pension funds do in order to match liability duration, the shortening of duration should therefore be Treasury bullish, ceteris paribus. In practice, however, what we saw is that increased inflation and policy interest rate expectations worked at cross purposes with the QE and so interest rates were not lower post-QE than pre-QE.
In the present situation, we are faced with a situation in which the US could default on its bonds voluntarily because Congress failed to raise the debt ceiling. This has been a long time coming. I wrote as early as November 2010 that the debt ceiling default issue would be a negotiating tactic we should expect Republicans in Congress to use. Voluntary default is a political risk that the United States has, much as Ecuador and Russia had when each nation defaulted voluntarily on bond principal and interest payments that they had the funds to make. In fact, I started calling US debt voluntary default the “Ecuador Risk Factor” in 2011. From a ratings perspective, this willingness to default voluntarily is a very serious risk for any sovereign debtor. I believe that it warrants additional downgrades to the US credit rating as I said when this issue was first raised. The risk should also slightly increase longer duration yields due to higher default risk premia.
Now, here’s the trade for investors.
If the US Congress were to authorise raising the debt ceiling, the US Treasury would match the deficit that resulted from expenditures which the US Congress has already appropriated by issuing Treasury securities as mandated by law. However, if Congress were to refuse to raise the debt ceiling, the US government would face voluntary default as it would not be legally permitted to issue more Treasury securities. Faced with default, the US government could mint platinum coins and deposit them at the Federal Reserve in lieu of issuing Treasury securities via a loophole in existing law (see here for a full explanation).
If the US government were to issue platinum coins in lieu of Treasury securities, this would effectively be an asset swap. Conceptually it is similar to what QE2 did, swapping long duration Treasurys for Treasury bills. Here with the coin, for US government liabilities we would be swapping interest-bearing Treasurys that would be issued if the debt ceiling were raised with non-interest bearing platinum coins if the debt ceiling were not raised. Therefore, the trillion dollar platinum coin idea means a net increase of coin seigniorage, draining income from the private sector that would accrue via bond interest payments.
As with QE2, there are no real economy effects here. This is an asset swap. The same logic applies here that we saw with QE2. Average duration for all Treasurys outstanding will shorten. Shifts in private portfolio preferences would be Treasury bullish and bullish for risk assets to where investing funds are diverted (stocks, corporate bonds, precious metals). In practice, we could get increased inflation expectations here. So despite the bullish impact of the shortened duration, it is not clear if the Platinum Coin would be bullish for Treasurys. Moreover, it is likely that the Platinum Coin would harden battle lines and further the austerity that was begun during the fiscal cliff debate. And this would make spending cuts and/or additional tax increases likely. That’s bearish for the economy and bullish for bonds.
Overall then, I would expect the Platinum Coin idea to lead to shorter Treasury duration, political gridlock, austerity and then recession. This is Treasury bullish, but bearish for risk assets. I will follow up this post with more ideas for Credit Writedowns Pro members as the debt ceiling crisis progresses.