The Oddness of a Present-Day Flight to Safety

Before legislators agreed to play a second game of debt ceiling chicken (this time with snow!), speculation over the possible effects a debt ceiling breach would have ran rampant. A surprising, at least on the face of it, conclusion, was that long-term Treasury yields would actually fall – here’s commentary from Raymond James along those lines*:

JPMorgan attempted to help answer this fundamentally impossible question by polling economists around the globe, asking them how they felt the long-end of the Treasury curve would behave if/when the debt ceiling was breached. Surprisingly, most said that felt long-term rates would actually decline as Treasuries would possibly benefit from a “flight to quality” even amidst the seemingly unlikely event of any missed payments. Unfortunately, the short-end of the curve could see heightened volatility as the October 17th debt ceiling deadline approaches, just as it did the last time we watched this same political gameshow in 2011.

Perhaps this dynamic would hold even under “normal circumstances” – investors don’t view the fight as a threat to the country’s long-term ability to service its debt, so there is no reason to sell longer term Treasuries. On the other hand, it’s not difficult to imagine that with Europe growing excruciatingly slowly, softness in the BRIC economies, and possibly overvalued U.S. equities, there’s still not a lot of great places to put one’s money aside from Treasuries.

One can imagine a similar dynamic (an issuer of sovereign debt experiences short-term problems, which leads to…greater demand for that same sovereign’s long-term debt) taking place in Germany. Spiegel International has a good overview of the issues facing Angela Merkel’s CDU in its negotiations with the center-left SPD over a grand coalition government. The SPD expects to have a government formed by Christmas, but it’s by no means clear they will succeed. The Greens have already ruled out governing with the CDU, so if talks break down with the SPD, Merkel may be forced to attempt a minority government (something that’s never been done in post-war Germany), or go to a new election.

Ordinarily this might be taken as a sign of instability and prompt a sell-off of German Bunds, but given the disastrous (alright, maybe that’s overstating it a bit) consequences a new round of elections would have for Europe and its ability to get its financial house in order (hard to see German politicians accepting a third bailout for Greece in the middle of another election campaign), all of a sudden German Bunds look like the safest place to put your money in Europe after all (at that point you might start wondering why any of it is still there in any asset class).

The German case is of course at this point an enormous hypothetical, and at any rate not at all similar to the American one. But in both cases the financial dynamics at play demonstrate investors’ belief in the immense short-term importance of each country’s economy to the global one, and the benefit of the doubt investors are willing to extend to each, on the expectation of long-term stability. This is an enormous privilege and one we can only hope does not get squandered.

*Update: This is the best I could find as a perma-link to the Raymond James commentary