Over the American thanksgiving holiday three years ago in 2009, the relatively small sovereign-linked debtor Dubai World announced it would suspend payments on its debt obligations. Dubai World was a state-owned conglomerate in the emirate of Dubai, part of the United Arab Emirates, and at that time, a locus of serious property overbuilding. This event had a butterfly effect in the debt markets as it caused a tumultuous correction in the pricing of sovereign risk that ushured in a sovereign debt crisis worldwide. Now some investors are talking about 2013 as if there will be another risk repricing. Here are my thoughts on this possibility.
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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.