Default Fears Start to Shake Investors

June 1st, 2011 at 10:05 pm | 23 Comments |

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In a vote that was not close, the House of Representatives rejected a “clean” debt ceiling increase Tuesday night, setting the stage for a summer of frantic debate before the August 2nd “drop-dead date.”   This sort of wrangling over deficits and the debt ceiling has already begun to worry international bond markets, as evidenced by Standard & Poor’s much publicized threat to cut the U.S. credit rating in April.

Nevertheless, some Republicans both in and out of Congress have hewed to the position that a short-term default would not be catastrophic, as long as it is brief and followed quickly by a deficit reduction plan.  Analysts outside the political arena have already debunked this fantasy, but there is reason to worry that even approaching a default could elicit some of the negative effects that would definitely come about if the U.S. were to actually stop paying interest on its debt.

As Steve Bell, the Senior Director on Economic Policy at the Bipartisan Policy Center, has argued on FrumForum, it is important to keep an eye on the spreads for credit default swaps (CDS).  These complicated financial derivatives are essentially default insurance policies for creditors, except that third-party speculators can jump in and bet against the debtor.  The spread is the quarterly premium paid by the buyer of the swap.

With American public debt in the $14 trillion range (a pre-existing condition) and lawmakers engaging in dangerous budget brinksmanship (a smoking habit), insurance premiums are on the rise.  In fact, the spreads for CDS insuring U.S. sovereign debt more than doubled in one day last week, signaling a dramatic loss of investor faith in America’s solvency.

Well, who cares?  This is, after all, the path our Congress has chosen.  Brinksmanship only works when people (in this case, markets) believe you’re crazy enough to blow up the world.  As long as interest rates on U.S. Treasuries, themselves, stay low and Congress does ultimately get America’s fiscal house in order, is it really worrisome that more investors are insuring U.S. debt?

Yes, because the CDS market appears to be where price discovery for credit risk takes place.  So, even though bond purchasers continue to charge the U.S. little to borrow money, CDS spreads reveal the market’s true feelings about the government’s creditworthiness.   At the moment, though, the bond market and the CDS market remain far apart, and, as Eric Burroughs reports for Reuters, real danger doesn’t come until bond pricing catches up to CDS spreads.

So, this raises the question, if CDS spreads continue increasing, how long do we have until the bond markets begin to react?  The answer is unclear.  There are data that suggest a 1% increase in interest rates for every 90-110 basis point rise in CDS spreads, but they are far from conclusive.  Also, spreads for U.S. debt still hover around 50 basis points, so the Treasury would not even see a 1% increase in interest rates until premiums doubled for a second time.

What is certain is that bond markets will not ignore the rising prices of default insurance forever.  If lawmakers continue to play chicken with the debt ceiling and stall on debt reduction to score political points, the U.S. may face rising interest rates and a shortage of lenders even before an actual default.  If Congress continues to threaten disaster, markets may just begin to believe them.


Recent Posts by Fred Messner



23 Comments so far ↓

  • armstp

    It just adds to the uncertainty and investors do not like uncertainty. The GOP is already doing plenty of damage to this country by threatening to not raise the debt ceiling.

    • Smargalicious

      All you have to do is look at the piece of garbage in the WH.

      There’s a key message here: Obamanomics and stimulus never works.

      First there was the massive Barack Obama stimulus spending. Then QE1. And now QE2 is winding down. And what did we get for all this? Slower growth overall, paltry job creation, more energy and commodities inflation, continued housing deflation, and virtually no new business start-up entrepreneurship.

      We know the Obama spending package failed to create a 7 percent to 8 percent unemployment rate, as advertised. And now we’re learning that the Fed’s QE2 has actually done more harm than good.

      All that money-printing stimulus worked to depreciate the dollar and jack-up commodity prices, especially oil and gasoline, but also food. So both companies and consumers have been punished.

      Some demand-side boneheads on Wall Street want the Fed to move to QE3, allegedly to fight a stalling economy. But if the central bank prints another $600 billion or so, all that will do is sink the greenback another 10 percent and drive oil and gasoline prices higher and higher. And that, in turn, will slow business and consumers even more.

      • armstp

        Smarg,

        As usual you have a warped sense of reality.

        1) every credible analysis shows the stimulus plan did work. It did exactly what it was suppose to do. It got the economy growing again. It stimulated.

        2) your 7% or 8% unemployment as advertised statement is bullshit. You should go back and read what was actually said. Romer said that their was one estimate (not her own) that said that the stimulus could keep unemployment below 8%. That is all they said. So the recession was deeper than this one estimate expected. Big deal. Nothing was ever guaranteed or said that the 8% was certain. By the way Romer also said the stimulus should have been bigger or closer to $1.4 trillion.

        3) Obama has orchestrated a very remarkable turnaround in the economy. We got back to growth in record time. Corporate profits are near record. Unemployment is coming down. Given the size of the shit sandwich that was left to him, he has done a great job.

        4) where exactly is the money printing? Not sure I see that. Can you prove this?

        5) Are you sure the low dollar is driving gas prices? Do you have proof of this?

        More quack economics from you…

    • armstp

      It is funny, but the GOP is the party that through the entire 2010 election was blaming a slow recovering economy on the UNCERTAINTY that Obama was supposively creating in the business community. What the hell is the GOP doing right now. They are creating tonnes of uncertainty with the BS political bullshit.

  • politicalfan

    Holding medicare ransom is not a bright move.

  • Graychin

    Boehner whines constantly about “uncertainty” in the tax code.

    But he’s indifferent to uncertainty in the capital markets.

    What’s his real agenda?

  • Hunter01

    So our creditors are beginning to hedge their bets, bringing the era of low-interest loans to a close. Who is going to pay the price for the additional vig? The affluent (by rescinding Bush tax cuts), the middle-class (by shredding Medicare and Social Security), or the military (by cancelling weapon systems in development)? Anyone’s guess but sure to be a battle royal.

  • ChallengingFrum

    are these articles deliberatly obtuse…S&P put out a warning on US debt because they were afraid that the government was NOT going to address the deficit…if you recall, the president issued a status qou budget with trillion dollar deficits as far as the eye could see…republicans requiring spending cuts to raise the debt ceiling….would only improve the governments credit rating

    btw…the picture and headline are deceiving…markets were shaken today not because of the debt ceiling …they were shaken because “recovery summer” is a fraud…Trillion dollar deficits ….2 Trillion in QE and the best the economy can do is 1.8% growth and 38,000 jobs….guess we need more stimulus

  • busboy33

    The GOP is in for a rude awakening. Money and special interests can only retain the reins of power so long as the apathy of the general population outweighs their self-interest. Most people will let them keep calling the shots . . . but only so long as you throw people a bone every now and then. The privileged minority cannot risk waking common minority.

    Tax cuts for the wealthy, attacking the promise of Medicare, cuts to services, fighting job-saving plans like the auto industry bailout, fighting things like the CFPB, attacking teachers . . . not only are they not throwing the public a bone, they’re actively taking bones away. Now they’re threatening the overall economy of not just America but the entire planet . . . again.

    And they don’t think there are going to be repercussions?

    • Grace

      Eh, calculated risk. As Mitch McConnell said, the #1 GOP priority is to defeat Obama. Think another worldwide recession might do the trick? It’s a Hail Mary pass that dwarfs the cynicism of McCain putting Palin on the ticket. At the very least, they’ll get draconian cuts that will create a major drag on recovery and if they’re really lucky, some significant shredding of the social safety net. Dems won’t deal? I think they’re prepared to blow it up. Remember: Party.First. They’ve really got nothing to lose with this play and I’ll give them even odds our worthless media will help them hang the default around Obama’s neck. They know their banker friends will get paid before any Social Security checks go out, so it’s all good. The bankers, meanwhile, have probably launched a thousand instruments to make billions off a default.

  • rubbernecker

    What Grace said!! Tom and Daisy will walk away, again, from the bloody pool.

  • ottovbvs

    Messner is wrong to connect yesterdays market decline to fears about the default. It was all to do with economic data, and maybe the dog days of Summer. The yield on 10 year bills actually fell below 3% which hardly suggests a rush for the exits on US debt. Nor do I buy his comments about CDS spreads being a discovery method for assessing the long term creditworthiness of the US. However, he’s correct about the ridiculous notions being peddled by Republicans that default would be no big deal or that it’s possible to engineer some sort of technical default where we carry on paying interest but effectively shut down most of the US government. The link to the JPM analyst he provides blows any such ideas out of the water. We’re not at the critical stage yet. After all Republicans have been assuring Wall Street that their vote Tuesday against raising the debt ceiling was a joke (in the words of one of the heads of the US Chamber of Commerce) so it’s easy to see why the financial industry regards all this political maneuvering with equanimity. Of course this also sent the message to the president that they weren’t really serious but no matter. The public of course is blissfully unaware of all this being more focussed on grilling burgers, tornadoes and Arnold’s girlfriends. This only starts to go critical when the govt has to start taking public steps to deal with the imminent shutdown of large parts of the US government machine, the issuing of SS payments, and settling bills for everything from missiles to grandads colonoscopy. This will be when the spaghetti hits the fan both in terms of public awareness and market reaction. The timing is in the government’s hands but they are going to have to start making moves in the next 30 days I would have thought. In the meantime expect more joke votes and irresponsible rhetoric from the Republicans.

  • SqueekyFromm

    This is wrong. Investor fears are not over a default but by a pretend recovery that has never really occurred. The “Default Fear” stuff is a distraction away from the real problems like PIIGS, Pretend and Extend, Fed Pumping, Faus-FINRA, and the fact that our major banks are INSOLVENT.

    Those sort of little things and all this FEAR, is just background for QE3.

    Squeeky Fromm
    Girl Reporter

  • ottovbvs

    by a pretend recovery that has never really occurred.

    Of course it’s occurred, GDP has recovered to pre-great recession levels, the auto market is going to be around 13 million units and even after yesterday’s dip the Dow is up over 90% from the bottom. Your ignorance is toe curlingly embarrassing.

    • SqueekyFromm

      Eau Contraire!!! What Planet have YOU been living on???

      http://www.zerohedge.com/article/yastrow-%E2%80%9Cwe-are-verge-great-great-depression%E2%80%9D

      Deficit spending has accounted for the growth in GDP, which is the same as saying:

      “Oh no, Mom! My finances are in great shape. I know I lost that $6,000 per month job, but now I bring home $3000 per month from my new job and borrow $3000 per month on my credit cards sooo I am right back to where I was before!!!”

      Squeeky Fromm
      Girl Reporter

      • ottovbvs

        Deficit spending has accounted for the growth in GDP

        You’re obviously deranged and I usually avoid discussions with such folk but you can count on the fingers of one hand the years since 1940 when the US hasn’t run a deficit. And since then GDP per capita has more than tripled in real terms from around $15,000 to around 50,000. Grow up.

        • SqueekyFromm

          YOU obviously can’t do simple math. Here is the GDP equation.

          GDP = C + I + G + (X – I)

          The “G” is government spending. It is the AMOUNT OF THE DEFICIT that is important. If you are spending more than you collect through the government expenditures that DEFICIT increases GDP just like the non-deficit amount.

          But, if the $ Amount of the DEFICIT is greater than the $ INCREASE in GDP, then you actually have a very questionable GDP number. Because you are including an amount that will have to be paid back out of future GDP.

          That is the same as the example above where I included credit card borrowings in my budget and said my finances were fine. That is exactly what we do with GDP accounting. Frankly, the GDP numbers over the last 50 years are screwed up because of this. This is about the same as keeping a company’s set of books on the Cash Basis. That P&L is a hell of a lot different from one kept on a Accrual Basis.

          In 2010 there was a GDP dollar increase of around $375 Billion. (Real $) The Federal Deficit for 2010 was $1.3 Trillion. (1,300 Billion).

          Sooo, now do you get it??? Subtract about $900 from the 2010 GDP ($1,300 Billion minus $384 Billion) and see what that looks like. Want a hint??? NO RECOVERY—NEGATIVE GDP of about 5%.

          That is why everybody is really screaming about the debt ceiling. If Federal expenditures are cut, the GDP is going KERPLUNK in a big way. The Default Hysteria is just cover-up and distraction.

          Squeeky Fromm
          Girl Reporter

  • indy

    What the hell? CDS spreads were 38.5 bps last time I checked. Compare that to > 150 in 2008 and a year ago they were >100. Even the WSJ’s debt ceiling panic alert level is still blue.

    • ottovbvs

      I think short term spreads have jumped quite a bit although long term spreads are very low relative to the panic days of 2008/9. So there may be some uneasiness out there about the debt ceiling. To be honest Credit Derivative Swaps are not a subject I know much about. But at the moment I really don’t believe there’s a lot of market anxiety out there about the debt ceiling because amongst other reasons the Republicans have been telling the street they don’t need to worry about it. This could all turn on a dime of course if things go pear shaped. Anyway have a nice day, it’s a nice one here so I have to hit the water.

  • SqueekyFromm

    Ottovbvs:

    OOPsies!!! Bad news for YOU. Lookit at what deranged little old me just found making my morning rounds of blogs:

    http://www.zerohedge.com/article/guest-post-can-we-please-stop-pretending-gdp-growing

    Excerpts:

    Submitted by Charles Hugh Smith from Of Two Minds

    Can We Please Stop Pretending the GDP Is “Growing”?

    The Federal Government borrowed and spent $5.1 trillion to get $700 billion in total GDP “growth” from 2008-2011. In constant dollars, there was no growth at all.

    The Federal government borrowed and spent $5.1 trillion over the past four years to generate a cumulative $700 billion increase in the nation’s GDP. That means we’ve borrowed and spent $7.28 for every $1 of nominal “growth” in GDP.

    In constant dollars, GDP is flat: we got no growth at all for our $5.1 trillion: zip, zero, nada. In constant dollars, the GDP in 2011 might return to the 2007 level, if the economy continues “growing” at the same pace reached in the first three months of 2011. If not, then the GDP will actually be lower than pre-recession levels.

    Full story at the link. Stop in there. Sit a spell. Read. Come back here. Apologize.

    Squeeky Fromm
    Girl Reporter

  • ottovbvs

    Full story at the link. Stop in there. Sit a spell. Read. Come back here. Apologize.

    You might want to learn the difference between the economic concepts of debt and output.

    • SqueekyFromm

      I know the difference. That is why I say GDP has not really grown. Read the Internet Article I provided you. What, you are happy to priss around when for 2010, we count $1.5 trillion in government DEFICIT spending in GDP, and still it only goes up $400 billion for the year???

      Sorry dude. That IS NOT a recovery.

      Squeeky Fromm
      Girl Reporter

  • ottovbvs

    I know the difference.

    You clearly don’t.