Monday, March 11, 2013

A Word on Risk Free (USA)

A Word on Risk Free (USA)

 A mistake is to lump all fixed income together, perhaps separated by broad based quality identifiers - US treasuries are lumped in with investment grade US credit and sometimes with any credit that is investment grade, like emerging market debt or foreign denominated debt.  Duration is not considered with only, again, broad strokes used to differentiate cash and money markets and long term.

This common stance and approach to investing or even speculation will almost assure failure in making money or realizing objectives.

The most important factor to understand cold is that the US "full faith and credit" debt - and this even extends to receipts or contracts - is risk-free, with no gradients or waxing and waning of that quality.  US debt is also the only "risk-free" debt, with all other sovereign debt quality defined by how that country relates to the USA in a myriad of accounting identities and political relationships and specific domestic characteristics.  But I want to talk only on USA "risk-free" debt, for now.

USA "risk-free" is not based upon a collateral value or total net worth of the country or the annual flow of funds experienced.  Though all of these do contribute or allow the deciding factor that makes USA debt  "risk-free".  The underpinning of the risk-free status is solely political.  It is the the seiniorage capability of the USA and the "rule of law" allowing for long term commerce and savings without the risk of undue confiscation or expropriation - at least explicitly. The 'rule of law" is , of course. entrenched and provided by the the USA constitution - so in the end it is the nature and the dynamics of change of the US constitution which allow for the USA to achieve "risk free" status.

Now of course the ability of the USA to have designed, implemented, and maintained the USA constitution is the happy good fortune of the USA to be formed at the right time and at the right place, with additional good fortune added upon that.  The entire constitution was tested by the Civil War, and was not found wanting nor was its essence changed by the test, only elaborated with additional amendments. And then as globalization and interacting on an international basis become the means of growth, and not continental expansion, the interaction of the constitution on the international front became important as well.   Social welfare and other transfer payments and support prevent revolution or insurgency, so the constitution is not challenged by domestic status or change.  So that leaves the international constitutional interface - the challenges and enrichment  - that are now the major area that weakens or strengthens the constitution. That leaves us with the challenges to the constitution by international forces and dynamics as being the main challenge to the USA "risk free" status.

Therefore it is the international dialogue of conflict that the USA has, and has had since WW I, which define and maintain the USA "risk-free" status.

"Risk-free" status is absolute, there are no shades of gray or gradients.  No "really risk free" or "sorta risk free".  The USA is either risk free or it is not.  That is why it is specious for the credit rating agencies to even bother offering an opinion of the credit worthiness of US Treasurys.

So - for the last century - the most important factor for determining the US Treasury yield curve has - now swooping down to the base - been the ability to wage war, if need be, and to offer a defense or deterrent to those who may damage the efficacy of the US constitution.  This is what I think Lincoln was getting at when he said the USA, the Republic, the "the last great hope of Earth".

Words which are relevant for a stock broker trying to figure out an appropriate asset mix for a client's portfolio, or the most sophisticated hedge fund searching for arbitrage opportunities.

It is the constitution and resulting rule of law which allow for the seiniorage of the USA currency, which is the starting point of building the yield curve of US obligations - money being that obligation which has an instantaneous duration.

This means that politics is what defines the US Treasury 10 year rate, in the end, not demand and supply, how much debt there is how little, what China is buying or selling, or  the demographic dynamics of the USA.     So it is the consideration of politics, the leading edge being the dynamics of US foreign policy, especially conflict, that one begins and ends the consideration of the entire US Treasury yield curve.  And ground zero for that political consideration is the value of money, and the next most important rate which is the Fed Funds rate.

To say you think China holdings of US Treasurys has something to do with the pricing of US risk-free, or that the Fed has bought a trillion via QE and therefore shifting the demand supply curve - that approach shows a fundamental ignorance of the make up of the US Treasury market and how price is determined.

After one understands and accepts that the pricing of US Treasurys is political, solely, and that leads to an unqualified "risk-free" status, the US Treasury yield curve can then be priced.  That is next.

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