K
  • January Article: Investments

    This Is Not a Case of Crying Wolf!

    By Bruce Kuhlman, Full-Time Faculty, Kaplan University School of Business 
    Published January 2014

    When the boy in Aesop’s fable cried wolf too often, people ignored him, and his imaginary wolf finally materialized and ate him. When the U.S. government closed for 16 days on October 1, 2013, the Dow Jones fell modestly but then increased to finish up strongly for the 2-week period. 


    In other words, financial markets treated the shutdown more or less as they would a boy who cried wolf simply to gain attention. If this boy cries wolf again, however, the entire globe could take notice and react dramatically.

    To understand why markets—domestic and global—could react differently to another U.S. government shutdown, consider the risk and return relationship as demonstrated in the basic equation for the required return on any investment:

    Wealth Management Graphic

    The return on short-term U.S. government securities, which are seen as default-free, is typically used as the risk-free rate of return in the equation. The risk premiums in the equation cover such uncertainties as default risk, liquidity risk, maturity risk, and inflation. The equation shows clearly that if any of the variables on the right-hand side of the equation increase, the required return on the asset must increase.

    Technical default is not meeting a financial obligation exactly as promised, amount and date. As with the October 2013 shutdown, another shutdown would cause the government to miss interest payments on its obligations. Domestic and international investors will start to develop suspicions that shutdowns are political tools to be used whenever politicians want to make a point. They will start to question whether interest payments, and even returns of principal, will be made in a timely manner. In other words, investors will question whether the U.S. government can be counted on to meet its obligations exactly as promised. U.S. government securities will no longer be seen as default-free.

    If this should happen, to entice investors into Treasury auctions (that is, into lending to the U.S. government!) the Treasury will have to start paying higher returns on all of its securities. With the increase in the required return on U.S. government securities (on the right-hand side of the equation), the returns on all investments must increase. With increased required returns come lower prices, and the prices of all outstanding financial securities will fall. The increase in U.S. government required returns thus could result in billions or even trillions of dollars of lost market value worldwide.

    The bottom line is that even though investors might have treated the October 2013 shutdown as a mere short-term political ploy, they will not look kindly on another shutdown, as they could see a potential pattern. Shutdowns will be seen as another form of investment risk. A rather intriguing question might be, “What country’s borrowing will now be used as the risk-free investment?”

     

    Bruce Kuhlman is a full-time faculty member at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.

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