Friday, July 11, 2008

Maybe it's another drill

This is the first time in my career that I truly believe U.S. Treasury bonds sold off on credit concern. By this I mean, the credit of the U.S. Government. Long time readers know I'm not an alarmist type, and I'm sure not saying the United States is going belly up, but credit default swaps on the United States of America moved 11bps wider today (from 9bps to 20bps). The 10-year Treasury moved 15bps higher. All on a day when people are scared shitless and there should have been strong demand for "risk-free" assets.

Draw your own conclusions. I've drawn mine.


santcugat said...

The whole situation is just amazing...

It seems impossible for the US Government to default on US dollar denominated bonds. Pretty much every other government default I've heard of has been caused by foreign currency debt.

Maybe worrying about the national debt will become fashionable again.

I wonder if Ross Perot still has some of those flip charts of impending doom?

Accrued Interest said...

Well I'm not saying the US can default. But if I'm looking at what's happening in the market, you have to conclude the U.S.'s credit is getting weaker, in the eyes of traders.

In other words, if JP Morgan CDS were 11bps wider and their cash bonds were 15bps wider, everyone would think those two trades were related.

Why not the US sovereign debt?

Thai said...

AI said... "Well I'm not saying the US can default".

I really admire your opinion and blog, and at the same time we are all entiteled to our own opinion.

As I said the other day on your 'ultra bear' posting, I don't really buy the view popular on Wall Street that demand for public debt CAN'T crowd out private debt and vice versa.

It looks like maybe, just maybe, we shall see (though I really hope not)...

cap vandal said...

I suppose the idea of the government dealing with the GSE's is driving this.

I don't get CDS's on the US. I mean, who the hell would buy them? Who would sell them. What's the trigger for the sovereign CDS's?

More to the point, what's the joint probability of a US Government credit event AND any leveraged financial institution (they are the entities selling them, no?) not having a credit event.

A lot of stuff just can't be hedged. Most true "black swan" events. Astroids. Nuclear exchange.

Cullen Roche said...

This Friday evening has a very eerie feeling with the IMB news after hours and the panic that seems to have set in on the business channels. There is no hope.

Will we see a 500 point drop in Fed Futures on Sunday evening?

Deja Vu all over again....

Leftback said...

Timely post on an important topic.

Amazing indeed. This may be one of those rare occasions when an emergency Fed rate HIKE might actually help to restore confidence. A small 25bp increase would act to strengthen the $ and arrest the oil price spike - while doing little damage to the already tattered balance sheets of failed institutions or the frozen housing market.

It's time for some real out of the box thinking - so much of what we are seeing is psychological, so why not draw a line in the sand right now? As we can see already, the Treasury market is quite capable of taking the law into its own hands.

Anonymous said...

Back link to your post:

adan said...
This comment has been removed by the author.
adan said...

truly scary, could be the drills are practice happenings, in case "it" happens, whatever "it" is

and though i'm firmly in the camp that believes interest rates are going down through the next few years because of deflation, i'm surprised how the idea of a tiny 1/4 point hike might be the tonic of interst, though i doubt it'd happen

anyway, for those who feel "the" fear level hasn't been reached yet...i don't know...even my wife, who usually sees all these financial crises as boy's games, commented tonight, "this is really bad...."

santcugat said...

Now I get it (from Bloomberg):

Contracts on Treasuries are quoted in euros and a basis point on a credit-default swap protecting 10 million euros ($15.8 million) of debt from default is equivalent to 1,000 euros a year.

Thai said...

We can not solve a debt problem with more debt. Increasing interest rates will not fix a solvency problem if the underlying causes are not fixed as well.

Sivaram V said...

NEIL: "This may be one of those rare occasions when an emergency Fed rate HIKE might actually help to restore confidence. A small 25bp increase would act to strengthen the $ and arrest the oil price spike - while doing little damage to the already tattered balance sheets of failed institutions or the frozen housing market."

I have to completely disagree. Raising rates now would be one of the worst things that you can do...

You will basically end up tightening credit and an already tight world, and probably push a few banks off the cliff.

As for oil, a small hike is not going to do anything given that most of the increase is due to higher demand from foreign countries. As long as they are demanding it, the price will go up. The only way oil will go down is if there is demand contraction (you are starting to see this in the developed world, and when the developing countries stop subsidizing oil, you should see more of it)... anyway, oil and inflation isn't really a problem right now--even if it were, it's driven by overseas actions...

Harleydog said...


Great Site!

agree wholeheartedly, rare to see treasuries sell off amidst panic and deflationary credit destruction around. Have foreign creditors had enough? is the jig up?

The TLT's look to have reversal bar yesterday. Time for the Ultrashort 20yr bond -TBT ?

Sometimes the hardest trade is the correct one.

Prudens Speculari

Patty said...

I am a real novice to this stuff. I bought a bond fund lsbrx thinking in bear markets bonds are good, and thought it would at least stay stable and provide a dividend. The nav has gone down almost every day since. To me, a treasury sell off in the face of a stock sell off has enormous global implications. Maybe this is a war that the Chinese will win without firing a single shot. They are so smart. Everyone thinks they will never call in our debt or dues but why wouldn't they? Maybe I'm being too melodramatic. You folks seem to know a lot more then me, are you selling your bond funds or holding? I would appreciate any advise.

JoshK said...

Maybe I'm a bit slow. The only fear should be for a US government bond holder that the Fed would monetize the deficit (more than they are now). How would the US government eer not pay the notes when they can just print out the currency?

Anonymous said...

when people say bps widened, the general standard is as compared to 2-year treasury notes?

Viktoria said...

Over the last year I've participated in a few "deja vu" conversations:
Cash manager's wishful thinking: the asset is "money good" at the end and there is plenty of liquidity in the portfolio.
Careful investor: what if you need to sell it?
Cash manager: I want to believe I can, but I don't want to find out.
The outcome of these talks is well know: 17 money market complexes had to buy assets from their money market portfolio. The assets are probably money good "at the end"; the advisor will likely to receive 100% recovery. The only worry is that a money fund investor is not to wait through "the end".

The last of my "deja vus" came on Friday: "I do see some cash going from our Government fund to Treasury", a Government fund's PM was saying, "I still want to believe I will be able to sell, if I have too, but I don't want to find out".

Now my "worst case" scenario. The size of the money market industry is about $3.5 trillion, close to 1/3 of it are Government money market funds. Size of these funds roughly tripled over the last your as a result of "a flight to quality". My estimate is about 1/3 of assets are from foreign investors for which Fannie/Freddie creditworthiness might be a tougher sell. So far money funds were only gaining cash, but at this point we may see the waive reversed.

Well known fact: if a money fund experiences 20%-30% outflow at 60-day WAM with spread widening of 300 bps it breaks the buck on marked-to-market. On average, funds are currently between 40 and 50 days and 300 bps in this environment is not unthinkable. The size of govvy funds is indigestible for most of investment advisor to support.

I'm not a GSE analyst to ponder on their insolvency; the black magic of the short-term market is in the instant transfer of any type of risk of the underlying assets into the credit risk of a money fund portfolio as a whole. [Ironically, the only money fund that "broke the buck" was a Government fund.] And contingency effect will finish it all.

Anonymous said...

Josh Kalish asked:

"How would the US government eer not pay the notes when they can just print out the currency?"

The US has both external debt obligations AND internal debt obligations that are particularly significant with the coming demographic wave of retiring baby boomers.

If the US, for some reason, wanted to get out of these obligations, two options come to mind: 1.) flat out default/restructuring, or 2.) inflate its way out.

What you are proposing, i.e. "just print out the currency" is an attempt to inflate your way out of an obligation. This MIGHT be digestible if the obligations were primarily external, but I find it hard to swallow that the US would inflate its way out of obligations to retiring babyboomers.

When you look at it this way, i.e. a choice between defaulting on mostly external debt or inflating retiring babyboomers into poverty, if it ever came to that, the former suddenly seems a lot more plausible.

scott said...

the monetization of domestic debt is a form of default.


do you mean a dollar deflation?

Accrued Interest said...

Again, I don't think the Treasury is anywhere near credit "trouble." I agree with Cap Vandal 100%, who the hell is the counter-party on something like this??

As far as monetization, while I agree that this would be a de facto default, I really don't know how the CDS language is written.

Another thing I've been wondering about CDS on municipals, but would also be relevant to sovereigns... When a corporatation defaults, the buyer of protection delivers a bond to the seller. Historically municipal government defaults have paid at or very near par. So your savings for having owned the CDS is very little. I have the feeling that a lot of CDS buying in munis has been part of "Chaos Trades" and now based on the fundamentals of muni defaults. I suspect CDS on the USA is following a similar pattern.

Anyway, I don't get quotes very often on the USA's CDS, but if I hear anything today I'll post it.

Unsympathetic said...


What do you think would be the knock-on effect of the weekend's activity being the signal that no more financial bailouts are possible.. that the only institutions they'll protect are Fannie and Freddie?

Accrued Interest said...

I don't really agree with that. So far the Bear Stearns and GSE bailouts haven't cost the government anything.

Basically what the government has done is ensured liquidity to certain companies deemed too important to fail, or more exactly, where their uninterrupted operations was deemed critical to the economy.

What they haven't done is take losses for anyone yet. They agreed to take losses ahead of JPM on the BSC deal, but those losses haven't happened yet.

So the question of capacity to take on more bailouts... there is plenty of capacity.

I don't know if we'll see more bailouts of this type. I sort of doubt it. Right now it is difficult for any bank or primary dealer to be in a sudden liquidity crunch. Lehman, for example, has access to huge amounts of cash through the Fed. So its nearly impossible for them to "jump to default." That isn't to say these firms can't fail, but that they'd have to go out of business the old fashioned way.

Greenie said...

Hi Accrued,

I saw almost similar paragraph to what you wrote in a different blog.

Who made the original observation, and who is faking here? Just curious.

Accrued Interest said...


I got an e-mail message from a bond salesperson which was a one line about movement in USA CDS. I've never even heard of this other guy.

rosy said...

If that were the end of the story, bonds would gyrate in price based on how close to a coupon date you are, creating all kinds of distortions in the market. To prevent this, bonds trade with accrued interest.

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