CDS Pricing in Increasing Treasury Default Risk

We have noted that Treasuries (and the dollar) are the remaining bubbles, although some doubts are starting to surface on the Treasury front. Paul Amery at Prudent Bear gives a good recap:

The tectonic plates underlying the whole superstructure of debt have started to shift.

On the surface nothing remarkable is happening – the 30 year US Treasury bond yield recently hit an all-time low of 3.88%, as investors sought a safe haven during equity market turbulence. Yet while nominal bond yields have declined, the credit risk component of US Treasuries has been on an increasing trend since last year. According to data provided by CMA DataVision, the credit specialists, the 10-year credit default swap spread – a form of insurance contract against issuer default – has risen steadily – from 1.6 basis points (0.016%) in July 2007, to 16 basis points in March 2008, to 30 basis points in September, to over 40 basis points on October 27 – see the chart below for the spread history so far this year. In other words the cost of insuring against a US government default has risen by 25 times in little over a year. Similar trends have been evident in the UK and German government bond markets.


This has perplexed, and even amused, some market observers. How, they ask, could a private sector contract against default be expected to pay out in the case of a US government default – which would be the equivalent of a nuclear explosion in the financial markets? So what’s the point of buying such a contract?

Moreover, how could the US government ever renege on its debts? After all, it supplies the world’s reserve currency, and the Federal Reserve Chairman reminded us a few years ago of the US authorities’ ability to print money in unlimited quantities. Any “default” would at least be through the time-tested mechanism of inflation and currency devaluation, according to this view.

On the other hand a longer-term examination of debt markets reminds us that, throughout human history, regular default is the rule than the exception. And while sovereign defaults on external, foreign-currency debt are most common, Carmen Reinhart and Kenneth Rogoff demonstrated in a paper released earlier this year that defaults on domestic debt have happened far more often than might have been expected, particularly in times of severe economic duress.

In both the US and UK, budget deficits are poised to explode….the really big impact is coming from the rescue packages being thrown at the financial sector. Morgan Stanley recently estimated that the 2009 fiscal deficit in the US would reach 12.5%, over double the previous record of 6%, set in 1983…

When measured as a percentage of GDP, the US national debt is expected to pass 70% next year, which, though much higher than recent years, is still short of the record 122% registered in 1946, at the end of the Second World War. Some observers point to this comparison as an argument for the sustainability of the current position.

Yet others argue that government debt must be seen in the context of, and as part of, the overall debt burden on the economy. With the US private debt to GDP ratio at levels never seen before – close to 300%, according to Steve Keen, the Australian economist – the question is surely whether the whole debt pyramid can avoid crashing down via a violent and uncontrollable chain of defaults, dragging the government bond market down with it. If this seems far-fetched, it helps to remember that the Latin root of the word credit comes from credere – to believe, but also to trust. For large sections of the private sector bond market, it is precisely that trust which has disappeared over the last year and a half. To suggest that such “credit revulsion”, to use an old term, might spread to governments’ debt obligations is surely not beyond the realms of possibility

Signs of strain in the US Treasury market are already there, despite the current low yields. Recent auctions have shown poor bid-to-cover ratios, and long tails (the difference between the average accepted yield, and highest yield), both signs of shallow demand. Delivery failures in the secondary market have also hit record levels, a sign of poor liquidity. Market observers should keep a close eye on the progress of future auctions, particularly as the issuance schedule picks up.

How can investors take cover if concerns over government solvency spread? For the early part of any credit-related decline in bond prices, there are obvious hedges, such as credit default swaps, short Treasury bond futures positions and inverse Treasury ETFs. But ultimately a US debt default would have cataclysmic consequences for the financial economy, bankrupting the entire system. So the ultimate safe haven is in the precious metals, which would rapidly regain monetary status in such a scenario.

5 Responses to "CDS Pricing in Increasing Treasury Default Risk"

  1. Anonymous   November 2, 2008 at 9:51 am

    Yves, even Roubini doesn’t sound quite this negative. Is this a high-probability scenario, or just a fit of catastrophizing on your and other market participants’ parts?

    • John   November 11, 2008 at 6:28 pm

      All I can say, is wake up ! Go look at the stock boards, the quicksand of debt is sucking the investors under. One day we jump up to say 700 points, then the next few days, we lose more then we gained. The Fed is pumping all this cash into circulation and nothing is happening. The reason is, the Fed printed so much money, it’s no longer holding it’s value, but the Fed continues to think it’s helping when it’s really filling the pockets of CEO’s and top henchmen. The tax payer can’t take this anymore, it’s hurting everyone. Another stimulus bill is’nt going to do anything either, the consumer is using it to pay down their own debts and nothing is going into the real economy as Bush thought it would. He thought people would go buy a nice new digital TV or whatever, but it did’nt happen. Consumers are in survival mode right now. They could care less about needless material items right now.

  2. Anonymous   November 13, 2008 at 1:35 am

    1.Credit crisis worsens and the money supply starts to shrink for lack of credit. The economy begins it’s descent into a deflationary spiral. Unemployment goes into double digits.2.The federal reserve starts lowering interest rates and there is a fire sale on US debt to the rest of the world.3.Deflation worsens, unemployment increases and the federal reserve tries to stave off a depression by ‘fixing’ the money supply by sending the overnight funds rate to zero.4.The banks take this ‘free’ money and put it on their balance sheets by paying off debt or giving out dividends or buying back shares or sending it overseas or into hedge funds or any other way they can pocket the money. Loans are at the very bottom of the bank’s lists to use the money.5.The federal reserve tries threatening the banks into lending but the banks ignore them. Stymied the federal reserve is paralyzed and does nothing. Congress and the President step in and attempt to inject liquidity directly into the market by making large emergency tax cuts and rebates.6.The federal deficit soars. There is a crisis of confidence in the solvency of the US dollar. The market for US debt dries up.7.Facing imminent bankruptcy the federal government passes laws allowing them to take money directly from the federal reserve in order to finance day to day operations.8.The markets realizes that the US government is going to risk hyperinflation and inflate their way out of debt. Everyone tries to unload all the debt they bought and as a result trigger the very hyperinflation they feared.9.Globalization fails spectacularly. The massive sale of US debt and the following hyperinflation turns the US into a monetary black hole that sucks liquidity out of the global market. The US has just stolen trillions of dollars from the entire world by selling dollar based debt and then hyper inflating it.10.The global economy goes beyond depression into a complete economic collapse.

  3. Anonymous   November 13, 2008 at 4:55 pm

    Could the Fed be preparing to squelch these rumors by “regulating” credit default swaps?

  4. phishna   March 6, 2009 at 1:52 pm transferred the data from the chart above onto 4 cycle semi-log graph paper. Doing so I was able to accurately project the US Treasury curve into the future. On semi-log paper the curved data points make a near perfect straight line, thus I can extend the line and calculate when CDS line will cross:100 basis points = 27 Feb 2009200 = 15 Apr 2009400 = 15 Jun 20091,000 = 15 Sep 200910,000 = 15 May 2009