More on risk re-pricing in 2013

Here is a brief economic commentary on US student loans. I have been fairly sanguine about some of the market turbulence in 2013. From the fiscal cliff to the sequester to the Japan rate rise to the Fed tapering, I haven’t seen a trigger for wholesale risk repricing. I want to flag student loans though because I think this could be a problem.

Back at the end of last year when I felt a full-scale fiscal cliff scenario would mean recession, I was still sanguine enough to note that you do need to get recession and some serious market black swans to get the kind of Armageddon scenario that people like Ray Dalio were talking about as an outlier. I agreed with Dalio that a 2008 repeat was unlikely but that what would make it likely was a large market discontinuity coupled with economic weakness.

I wrote:

“it takes more than just a bad economy to force a wholesale risk repricing that includes the so-called risk-free asset which serves as the anchor for discount rates and other asset classes.

“A more plausible scenario is that risk assets sell off as the risk re-pricing causes risk premia to increase. That would mean asset classes like Student loan-backed asset backed securities, high yield bonds and equities would sell off while US Treasuries continue to act as a safe haven. The right trade in this scenario would be to be long Treasuries and short risk assets or simply long volatility as a hedge against one’s portfolio.

“So if 2013 does see the US go over the fiscal cliff, the economy would stall and recession is the likely outcome. Even in a clifflet scenario, recession is possible. But this is simply not enough to cause a risk repricing. We would need a trigger event like Dubai World. Something like a student loan asset-backed security default to trigger a flight from risk assets and a general repricing of risk. Moreover, even as risk reprices, Treasuries will remain the risk-free asset and so while policy rates will remain at zero, expectations for future policy rates will ratchet down and long-term gvernment bond yields will come down accordingly.”

What we have seen so far is that risk assets have indeed sold off but that Treasuries have also sold off. This has caught Ray Dalio out as his All Weather Fund was looking for the long Treasuries, short risk assets trade as the right hedge. Going forward, I expect the Fed to maintain its stance of zero rates and tapering assets only when the specific unemployment rate criteria it has outlined are met. A couple of months ago, I thought the Fed could taper as early as June because of pressure from hawks. However, it is clear they will stay with QE for longer. The revision in Q1 GDP in the US tells you that the risk is to the downside as I have been saying – meaning the Fed’s forecast is too bullish. The Fed will taper later and stay accommodative longer if things play out as I believe they will. William Dudley was out today saying, market expectations of earlier fed rate hikes are “quite out of sync” with FOMC statements. That’s according to CNBC’s Steve Liesman, who also tweeted that he “Can count on 1 hand (maybe 2) the # of times a Fed official has made such direct remarks on rates relative to policy as Dudley just did”. That’s telling you the Fed is not going to taper early. And that means the Dalio trade will start to look better, with risk assets staying weak or getting weaker while Treasuries begin to rally as the market appreciates the economic weakness.

What would make the All Weather trade outperform even more, however, is a major cock-up by the US Congress on the fiscal front or in some other arena. For example, take student loans that I mentioned in December; here is the latest state of affairs:

Bloomberg: “Student-Loan Rates Set to Double Unless Congress Acts” –

With just two working days left before the U.S. government doubles some student-loan interest rates, lawmakers are haggling over what to do about it.

The argument isn’t over whether to allow rates to rise above 3.4 percent, the level set by law until July 1. It’s about how much borrowing costs will increase.

“The likelihood of students keeping the interest rate they had for the last two years is diminishing by the hour,” said Terry Hartle, vice president for public affairs at the American Council of Education, the largest lobbying group for colleges and universities. “The outcome will be students will pay more than 3.4 percent in the short term,” he said in a telephone interview.

Unless Congress acts, the interest rate for subsidized Stafford loans for undergraduates from low-income families will increase to 6.8 percent from 3.4 percent. More than 7 million students use that direct-from-Washington loan program.

[…]

Complicating the talks is the 55 percent increase in the yields of 10-year T-bills, to 2.54 percent, since May 1.

Under a House-passed plan, that would have meant a student loan rate of 4.3 percent, rising to as much as 8.5 percent. 

So, as with the fiscal cliff, we have a race against the clock here. And as with that outcome, all scenarios are negative with some being substantially more negative. The benign outcome is a deal that increases the student loan rate marginally. The Armageddon scenario is a doubling of student loan rates, followed by massive defaults, market dislocation and economic disaster. Now, remember that the US is at stall speed. We know this after the Q1 downward revision. We also know that job and wage growth is poor while more fiscal cuts and a potential debt ceiling battle are in the pipeline. The US is not out of the woods by any stretch.

If we get a bad outcome on student loans, I believe it will usher end a wholesale risk re-pricing that will be catastrophic for high yield, leveraged loans and emerging markets, the frothy areas already selling off on the tapering news. But the real economy impact in terms of credit growth will be equally negative, setting the US up for a big problem. This is a political issue, so the outcome is ot certain. But you would think they realize that a deal is necessary. Nevertheless, hedging for no deal like Dalio may be wise.

My baseline view here is about where it was six months ago – still for a continued modest re-pricing of risk assets but a major equities correction in the US – now without recession. That’s certainly more bullish than I was before the housing rebound and fiscal clifflet combined to put recession on the back burner. The things that could torpedo my more upbeat view are numerous, however. In the US, watch the student loan deal over the next couple of days and the fiscal negotiations later in the summer. Outside of the US, I would watch China and the other BRICs, but particularly China because their experiment with tight credit liquidity is potentially the most explosive EM thing to watch.