Markets Signal US Default Likely

This dangerous game that the US congress and the White House are playing just got very real.  How real?  The Credit Default Swap market just gave a strong signal that a US Government default is likely.

Today's curve (red) is 'inverted' compared to all previous curves. This usually signals that the issuer (the US Government in this case) is about to default. Source: Bloomberg.

The figure tells the story: the red curve (today, Tuesday July 26) is ‘inverted’ as compared to all previous curves (in other colors).  When this happens to a company, it’s a signal that the company is likely to default on its loans.  In this case, it applies to the US Government.  In other words, market participants are putting their money on a higher probability of default.

How should you read this graph?

This is a graph of the price of a Credit Default Swap (CDS) on US Government Debt for different periods of time into the future – from 6 months on the left out to 10 years on the right.  The yellow (lowest) curve is what the prices were a year ago.  The orange curve is for 3 months ago, the green curve 1 month ago, the blue curve 1 week ago and the red curve is for today.  You can think of a CDS as insurance against default for a particular issuer.  It applies to companies and governments alike.  If you buy one of these CDSs, you get paid money if (and only if) the issuer defaults.  So these curves tell us how expensive it is today (red) and has been recently (other colors) to buy insurance against a US Government default.

Under normal circumstances where the issuer (in this case the US Government) has enough money to fund its ongoing operations, these curves should all look like the yellow/orange curves – upward sloping.  That’s because in the short run, the issuer has enough money to pay what it owes and things only get riskier far in the future.  But if the credit quality of the issuer starts to deteriorate, the curve tends to flatten (like the green and blue curves).  If a default is likely, the curve becomes inverted (like the red one).  The interpretation of the red curve is that in the short run the issuer has real problems (high risk) but if it’s able to overcome them, then in the long run things will be better (lower risk).  Put in terms of dollars and cents, it costs more to insure this issuer now than it will in the future.

This is the first time that the US CDS curve has ever been inverted.  So this graph tells us that for the first time in history, the markets are considering a US default as likely.

2 Responses to Markets Signal US Default Likely

  1. Paul Reniere says:

    Very interesting graphs on US CDS thank you for sharing them. But I think that if USA was to default or was on the brink of default the 10 Year US Treasury wouldnt be at a low for the year and yielding 2.66%. When a country is about to default yields would be exploding to the upside like we are seeeing in Greece and now starting to see in Italy.

    The charts are interesting but I dont believe they are giving us any indication that USA is about to default. If these charts AND the US Treasury yields where hitting highs I would agree with you that a “US Govt default was likely”.

    • Paul,

      You’re point is correct – the US Treasury markets did not signal any concern about what might have happened. Neither did the equity markets, really. But the CDS market gave a very strong signal. I do want to be clear that I did not say that it was likely that the US would default. My claim was that the CDS markets were saying that, and it’s the first time they ever did so. No one knew what the US government was going to do and whether or not it would have increased the debt ceiling. Some markets, as you point out, said ‘it’ll all be fine.’ The point of my post was that for the first time ever, a major market (CDS) pointed to the US defaulting.

      Damian

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