The 1:1 debt ceiling spend cut swap

House speaker Boehner has laid-out what may be the most important government speech for 2011. In front of the Economics Cub of New York, the Speaker suggested that a dollar of debt ceiling could be expended for a dollar of deficit cuts. While this type of constraint would be unusual, there is past precedent for binding behavior. In fact, the only way to control behavior may be through a set of rules which limit activity.

An increase in the debt ceiling without any constraint on spending would mean that the debt ceiling would have no meaning. Any rules-based system has to have some penalty if standards or thresholds are breached. What some would like is a debt ceiling which does not have any consequences. If a new ceiling is hit it should be raised ago because the ill effects of not raising it would be so large. Taken to an extreme, the debt ceiling could be set each month and then raised each month if it is hit. If that would be the case, then there should be no debt ceiling at all. If the government cannot suffer any consequences and the market supposedly does not care, then it should be eliminated. However, the ceiling has been passed by the government in the first place to limit extreme spending behavior.

Reasonable constraints would be to require automatic cuts if the threshold is hit. Since that may occur at the wrong time, the alternative would be to tie cuts to a raise in the limit prior to passage. Since the debt ceiling is supposed to apply for a lengthy period, (in the extreme that should be forever), a cut in long-term spending in exchange for an increase would be reasonable.

The ongoing Greek problem

The choices for solving the debt crisis are actually very clear. Austerity or default. At some level as debt levels reach an extreme, the choice is singular, default. This case is simple. If the size of the debt is greater than GDP and the rate of interest is greater than the growth rate of the economy, all of the economic growth and then some has to be used to pay interest to bondholders. Extending maturities woud not help. Lowering interest rtes would be helpful but only if the rate would be below economic growth.

This extreme is where we may be at with Greece, but we will have to continue to play this issue out because the lenders have an incentive to avoid the default. The Greeks at this point may welcome default as an alternative to more years of austerity. There will be an adjustment but the would like to go forward in a different environment than what exists today. Taxes have to be paid and services reduced in order to pay bond-holders.

A restructuring is needed and bond-holders are going o have to take a hit. This could be pushed forward a little longer but the end result will be the same.

Commodity volatility, cascades, and margin

We should accept the volatility in market which is tied to specific events or announcements. When information changes, markets change. What is harder to take and more dangerous is the risk from price moves that are not tied to specific event or when a seemingly small event leads to a large change. This is what happened in the commodity markets last week.

Commodities were hit with massive sell-offs with strong declines in silver in energy. Everyone was talking about a silver bubble and the sell-off may have been localized because of margin increases, but the general price decline was unexpected. Analysts have to engage in the old game of trying to link news to a market event even if the correlation is tenuous. Nevertheless, we can still try and make a case for a commodity sell-off.

The slowdown in US economic numbers coupled with the lack of action by the ECB were the op stories in economic news. These could easily be argued to be at odds with a commodity sell-off. Clearly a sell-off in oil should be expected if there is a slowdown in global growth, but Libyan production has not been offset by Saudi pumping.

The alternative explanation is that markets are subject to cascades or massive changes in expectations which may feed on themselves. This seems a more likely explanation when a market moves to extremes. With speculative positioning moving to extremes, any small change in the cost of holding position will lead to profit-taking. This may have started in some commodity markets when margins were increased, but carried over to others under the believe that there will further increases in margin.

We could call the sell-off of May as the increased margin cascade. Margins are used to support the clearinghouse, but increases change the calculus of profit. Higher momentum is necessary to support the market.If that higher price action is not expected, profits will be taken and the sell-off will begin. The feedback loop will continue given the cost of trading has increased.

ECB hold on policy unexpected

ECB president Trichet signaled that rates are on hold until after June. So much for the inflation fighter. The market has been expecting a rate rise to match the higher inflation in the EU. It is going to have to wait. The currency markets reacted immediately with the upward trend in the Euro reversed. Trichet stated that the ECB never "pre-committed" to change. He also did not use the words "strong vigilance" instead he stated that the bank is monitoring inflation "very closely".

After getting ahead of the Fed, with a rate rise, the ECB seems to be more closely following the view of the Fed that commodity prices may be peaking and that the increase in food and energy prices will slow in the second half of the year. If there is a slowdown, there will be less need to raise rates and place downward pressure on European economies.

Core Euro-region inflation is still only 1.3% which is very much in check, but the PPI is hovering around 6% and headline inflation is above the target rate. Given the often loose link between rate changes and inflation, it is hard to fix what should be the right interest rate, but the ECB has other things to worry about. A strong Euro hurts exports and any slowdown will carry over to debt issues.

It seems like the ECB action is more of a stop the Euro rise type of response.