We’re seeing one of those odd occurrences again where USA CDS are surging higher and bond yields are moving lower (thanks to Joe Weisenthal for pointing this out).   Earlier this year I discussed the exact opposite phenomenon.  What we were experiencing was a period of marginally higher inflation due to stronger economic growth and a flat line in USA CDS.  At the time, many were talking about the stirring “bond vigilantes” and how they were about to bring their doom and gloom down upon the US economy.  Of course, that didn’t happen and neither did the hyperinflation.

Today, it’s the US debt ceiling and our impending default that has investors worried for no reason other than their own lack of knowledge with regards to the real workings of a modern fiat monetary system.  Interestingly, we’re seeing the exact opposite price action from earlier this year.  USA 5 year CDS (priced in Euros) are rising and bond yields are falling.  Markit provided a snapshot of the situation:

“The US, however, has seen its one-year spreads widen significantly in recent days and move well above the UK’s. The long-term fiscal challenges that the US faces are well-known but these are irrelevant for the short-end of the curve. Recent activity data from the DTCC shows that the number of trades referencing the US has gone up dramatically and was five times that of the UK last week. It appears to have been triggered by concerns over the US debt ceiling and the possibility of technical default. This seems far-fetched to European observers but is the subject of intense political debate in the US.”

But the 10 year US Treasury continues to decline.  What in the world is going on here?  Why aren’t yields pricing in default risk like the CDS market is?   Well, it’s just another real-time view of the inefficient market at work.

The CDS market is concerned that there is some risk of a US technical insolvency so we see hedgers bidding up prices.  The bond market, however, sees no risk of default.  They see only lower inflation.  Now, this is an obvious flaw in market dynamics for anyone who understands how our monetary system works.  After all, there is no such thing as the USA being able to turn into Greece.  There is no such thing as the USA being able to “run out” of the currency that only it can produce.  It cannot become insolvent in the same manner that Greece can.  As a sovereign supplier of currency in a floating exchange rate system with no foreign denominated debt it is entirely impossible for the USA to become insolvent in the traditional manner of not being able to make payments in the currency that only it can print (boy, that was a mouthful!).

The only form of insolvency that the US government could suffer would come in the form of hyperinflation.  Regular readers are familiar with my research on this and know that I have believe hyperinflation has been a non-issue for many years now and still believe this today.  So, if the USA was becoming insolvent yields should be surging as bond investors flee US Treasuries.  Clearly, that’s not occurring.  So, there’s a clear market inefficiency at work here.  One of these markets is 100% wrong.  And if you understand the workings of the modern monetary system it should be abundantly clear to you which market that is….


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Two things driving the trade are cheap way to play EUR relative to USD (use Germany vs USA protection) but main one seems to be a play on some of the cheapest-to-deliver TSYs should a technical default occur (delayed payment etc). Just as you say, there is no real default given money printing etc BUT technically it could trigger CDS and then auction process kicks in and bonds will need to be bought and delivered and if you scan the prices of TSYs, you’ll see some sub-par CTDs that might be used.

  2. If inflation expectations are subdued going forward, are we looking at lower and lower and lower rates? Obviously there will be fluctuations but it is hard to imagine a scenario where rates increase dramatically. If this is the case, there is going to be real problems as retirees struggle to find income and pensions struggle to meet their 8% return targets.

  3. Tough to make much of this market…US CDS rarely trades. But, for some reason, the number of contracts has exploded in the past week…who is making big bets here all of a sudden? What do they think they know? Where do they think the upcoming catalyst is?

  4. “seems to be a play on some of the cheapest-to-deliver TSYs should a technical default occur (delayed payment etc). Just as you say, there is no real default given money printing etc BUT technically it could trigger CDS and then auction process kicks in and bonds will need to be bought and delivered and if you scan the prices of TSYs, you’ll see some sub-par CTDs that might be used” I understand and agree on the zero chance of any real default regarding U.S debt but could you expand more on the CTD relationship to CDS. Do you mean cheapest to deliver against futures contracts on the CME or something different. Forgive my ignorance.

  5. There is another explanation of that phenomenon.
    Big fish are hedging their positions which they have (or will) in the US Treasuaries.

  6. B Ferro,

    I read somewhere that Bill Gross, for all his bearishness on US Treasuries, is shorting US CDS. Sorry I can’t find the reference.

  7. what if the congress cannot reach agreement for the debt ceiling? It might seem ridiculous, but the CDS market is smart money business, not some retail investors with 20k account.

  8. I don’t believe there is anything that wrong with the market here.

    If you think that the GOP is bluffing you simply do not understand the political situation. A hard lesson or two will have to be learned before the extremists are pushed out of that party. They have completely gone off the rails.

  9. After reading this site for about six months I certainly understand that we can’t default in the same way that Greece, etc can. BUT, why are you not more concerned about the ignorance of politicians who could actually trigger a default by politically not ALLOWING the gov’t to pay its debts?? The article in the NYT yesterday about Grover Norquist and the “no new taxes” pledge would seem to be pertinent to me here.


  10. They’ll still have the tax revenue to pay interest on the debt and repay maturities. But it will shut down the rest of the government and even delay things like SS and Medicare.

  11. lol,

    no, not necessarily pick up the pace, but quit using the word “cannot default” unless it is accompanied by “unless the stupidity of politicians allows it to happen. Used to be, you said we could only default is someone went golfing and refused to push a button. Now, I think you have to add in “or because I underestimated the depth of obtundation of politicians!”

    emoticon added!

  12. Yep, it’s the old story again. TPC still doesn’t like to see reality. Yes, I’ve read what TPC’s take is and I still don’t buy it. Yes, the FED could monetize the whole “kit caboodle” but it won’t make a difference.

    The USD being the reserve currency means the US can “push it” but once interest rates in the US start rising in earnest then we’ll see how fast the US will break down. One has to look at it from a standpoint of an investor. If interest rates go up then every sane investor will sell his/her bonds. The same happened back in the late 1970s. US interest rates went up and that’s why foreign countries started to reduce their buying of US T-bonds and even reduced their US T-bonds holdings. They preferred to hold their USD in cash, instead of holding t-bonds which go down in price. And that pushed up rates up even more. That’s why Paul Volcker was forced to tighten the monetary screws.

    The same happened to Agency paper in 2008. Up to say, july 2008, foreign holdings of Agency paper was still increasing but in july 2008 foreigners started to DUMP/sell aggressively their Agency paper. Up to july 2008 the US still could count on foreigners to buy that Agency paper and US financial markets were, more or less, still doing OK. Then as result of foreigners selling their Agency paper the situation turned from “doing OK”” to VERY ugly. and that’s where the largest seller of MBS garbage to foreigners, a firm called Lehman Bros., was “”severly hit””, took a turn for the worst.
    That’s why the US gov. was forced to take those Agencies into “conservatorship””. And then the whole “kit caboodle” went “to hell in a handbasket”.

    Substitute the words “Agency paper”” with “Treasuries” and it will become clear what’s in store for the US.

    There’s however one question that needs to be answered: If the FED monetizes US T-bonds, where are the interest payments for those monetized bonds coming from ? From the US government ? Or does the FED need to monetize more debt as well ? If t comes from the US government then I would think that when tax revenues are shrinking dramatically the jig will be/could be up for the US very very quick.

  13. @Willy2

    Can you point to a single historical example where the world’s reserve currency blew up in a matter of months? Can you seriously consider some other form of “currency” to handle all international monetary transactions? The yuan, the euro, swiss franc, the Myanmar kyat? (sorry, the kyat was a bit facetious)

    Gold? It will still be interpreted through electrons and buttons on the international scale. i.e. through fiat………

    Are you postulating the entire collapse of the fiat system, cuz in the short term, how can hyperinflation of the US$ could occur without that happening?

    The demise of a world reserve currency will be linked to the demise of the world superpower which backs that currency and right now, we’ve still got the biggest guns on the planet.

    No, I don’t think the US$ is infallible in the long run, but what other medium of exchange will SUDDENLY take its place??

    Our fiscal policies right now are a mess in many ways, but for hyperinflation to occur AGAINST ALL OTHER CURRENCIES, would mean we’re screwing up more than anyone else. Can you honestly say we’re doing worse than the Eurozone, or China, or the emerging markets with their ruling families and oligarchies and one resource economies?

    I’ll hedge my bets but I don’t think the momentum of this battleship is suddenly going to be arrested.


  14. Thanks to Mr. Roche and Mr. Mosler, I’m having my best May ever. The “bumper crop” of dollars really isn’t materializing, MMT has really been a crystal ball lately.

    However while I am long treasuries I don’t feel safe shorting USA CDS (I don’t know how anyway :)). It’s too hard to predict the politicians.

    Re: (hyper)inflation, I don’t see it. Our trade deficit is mostly energy and China, otherwise most places still want to transact with us, and as our currency weakens they will consume (are consuming!) more of our stuff. Re: energy, we’re getting the price signals now to adjust, it will take a while and we won’t have great growth until we do but look at the progress we made on energy intensity in the 1970s, plus we have domestic resources like natgas to develop. Re: China, I’m less clear on how that resolves but as long as they continue on the current path they will be net deflationary to US.

    In any event I am not convinced that inflation per se sets treasury prices, but rather the expectation over future distributions of overnight rates over which the treasury can be replicated. Sure in a sane world inflation would be met with a policy response by the Fed changing the overnight rates … but they’ve already shown a willingness to measure inflation in a way that does not necessarily correspond to the “man in the street” notion. The Fed seems to care about labor market slack more than anything, so until unemployment (CNY-USD?) shows movement I’m feeling good about UST.

  15. @TPC: CURRENTLY I am a DEFLATIONIST !!!! That doesn’t mean that we can have bouts of (higher) (Price) inflation as a result of e.g. QE 1, QE 2 or exchange rate movements, (severe) supply&demand issues. But as long as US housing prices are on a downward trend there’s – IMO – no “”snowball’s chance in hell”” that we’re (about) to experience chronic (hyper-)inflation any time soon. Because a lot of Agency paper and T-bonds have been sold around the world.

    Higher US interest rates will be the result of investors being forced to sell their bonds in an attempt to stay afloat financially. This is the result of ever decreasing yields on e.g. US T-bonds. And then foreign will follow and start selling their US T-bonds as well. That’s where “the shit will hit the fan” for the US.

    But rising US interest rates won’t be the result of (Hyper-/high) inflation. That’s the mistake a lot of Inflationistas are making.

    Besides that, the FED has painted itself into a corner by monetizing a lot of T-bonds. The FED has effectively become the market. So, all that talk about an “exit strategy” (=selling bonds or MBS paper) is a dog and pony show, kabuki. If the FED would start doing so TODAY, then interest rates in the US would start to go through the roof TOMORROW.

    I referenced to the (late) 1970s in order to explain what – IMO – will happen with interest rates in the US in the next e.g. 6, 12 or 18 months and why it will happen. But the financial environment of the 1970s is a different one than the current one. So, all that talk about (hyper-)inflation is CURRENTLY sheer nonsense.

  16. Suppose I was an (Hyper-)inflationista. Then I would be a fool to be “”long”” the 30 year T-bond, wouldn’t I ?

    And I am “long” the 30-year T-bond (future).

  17. Yes, the US still has the biggest guns but those guns are paid for by using Uncle Sam’s credit card. And sooner or later that credit card is going to be withdrawn. Some day the payment check(s) of the US WILL bounce.

    Why should there ONE world’s reserve currency only ? Because it has been so for the last say 100 years does not mean it will be so in the future.

    Yes, the US army is the largest one on planet earth but that’s precisely the reason it’s one of the weak spots of the US as well. US military spending is so outrageously large that it threatens the financial health of the US. Time to cut back on military spending but it won’t happen because too many folks are profiting from the military budget.

  18. What CDS buyers are aiming for is just a ‘technical’ credit event, Repudiation/Moratorium, which could be triggered by public statements by the administration or the Treasury. If this Credit Event is triggered, then long-dated zero-coupon USTs, trading around 85 pts, are deliverable into the contract, and the owners of protection would get paid 100-85 = 15 points (approximately). They consider that paying 40-60 basis points for a year to buy that option is a worthwhile trade that’s all — USA creditworthiness is not part of the trade rationale, in fact should the scenario occur it wouldn’t be surprising to see a squeeze in the long-dated deliverable obligations and yields would actually fall further.

  19. About being an (Hyper-)inflationista:
    1. I was long Treasuries from april 2010 until late august 2010.
    2. Went short the 30-year T-bond in late august 2010. But I was right for the wrong reasons. I didn’t expect the stockmarket rally (september 2010-april 2011)to last this long. Although I was long silver.
    3. Now I am long the german BUXL (30 year) future and looking for an entry point to go long the USD, to go short silver, gold and more stocks. After all Germany has a current account surplus and is therefore not dependent on foreign financing like the US.

    Going long Treasuries, the BUXL and the USD, does that sound like an (hyper-)inflationista ?

    More over: DEFLATION is a credit destruction process (Source: (James) Grant’s Interest Rate Observer). And that’s precisely what’s happening today. And only when (nearly) all the credit has been destroyed then we could enter a (Hyper-)inflationary period (Bob Hoye).

  20. Not sure I follow. When you say “85pts”, do you mean they are trading 85 cents on the dollar? Last time I checked, long-dated UST strips were trading around 25 cents on the dollar.

  21. This is a sloppy post. You have 10 year yields in one chart and 1-year CDS in another. Let’s keep things simple and leave them all on 5-year. 5-year Treasury are 1.81% (1.97% start of May), 5-year Tips are -0.26% (-0.48% start of May), 5-year breakeven inflation is thus 2.07% (2.45% start of May), and 5-year US sovereign CDS is 49.5 (from 43.9 at start of May).

    So what we have seen is a rise in sovereign CDS spreads and a decline in breakeven inflation. Since we can hedge the inflation risk of a T-note, we really care about the 20bps rise in the real yield. Of that a portion is a real risk-free return and a portion is compensation for risk. Since the CDS rose about 5bps, we know that approximately a quarter of the rise in real yields was due to an increase in the risk associated with lending to the U.S. government. This part of the story is actually the opposite of what you’ve been saying.

    Even if it were, while there might be some theoretical correlation between breakeven inflation and CDS spreads at some point, you do not provide any evidence of this historical correlation. How well has Portugal’s CDS tracked its breakeven inflation? I would guess not well at all. It very well could be that the market increased its forecast of a technical default, but not one that would require printing a bunch of money. Since the technical default would increase uncertainty and could possibly damage growth, breakeven inflation might fall. Alternately, there may be no reason for these two things to be correlated until they blow out.

  22. The point is about solvency so no, there’s nothing “sloppy” about it. Pull up a chart of Portugal’s 10 year bond and 1 year CDS. You’ll see that the action is distinctly opposite of anything occurring in the USA.

  23. rhp, to answer your question, “Can you seriously consider some other form of “currency” to handle all international monetary transactions? The yuan, the euro, swiss franc, the Myanmar kyat? (sorry, the kyat was a bit facetious)”

    The answer to that would be SDR (special drawing rights) a synthetic currency. During the Bretton Woods summit after WW2, we almost went to a BANCOR system, which is synthetic currency.

    Here’s a quote found at in the following link: “the governor of the People’s Bank of China suggested last month that the global monetary system would benefit from revamping the role of the International Monetary Fund’s special drawing rights (SDRs) to create a uniform global reserve currency.[i]Arguing that the Triffin dilemma[ii] was at the root of the present crisis, Zhou Xiaochuan proposed that SDRs take on the role now played primarily by the dollar (and to an increasing extent the euro) as the reserve currency of choice.”

    Recent news stories have China wanting to shake up IMF representation so China is more prominent (to reflect reality. Chinese representation in IMF means the idea of a shift to SDR’s becomes less fantastical.

    Triffins dilema in a nutshell says that a reserve currency country can have problems with twin deficits. One deficit is to supply reserve dollars to a world in need. The other deficit is to stimulate the U.S. private sector, like what is happening today, in our balance sheet recession. A bancor system would eliminate the need to supply the world with reserve dollars via trade imbalance.

    Another benefit of the Bancor system, is the flow of fiat currency would circulate only in the local economy. This would make the fiat system more simple and robust. Mercantile behavior, like that of China and Germany would quickly show up as imbalanced Bancors in the trading banks. Law could be in place that would confiscate excess trade imblance monies, a penalty for mercantilism. Zhou was right, a system with Bancors would benefit the U.S., and may actually harm China.

    We currently artifically hold dollars high (supply and demand, where dollars are desired due to reserve status). Meanwhile, other countries are in a race to the bottom to acquire dollars and thus their need to export to the U.S. The U.S. is always importer of last resort.

    This screws main-street American business, as they have to compete using a strong dollar against race to the bottom foreigners. Dollars as reserve are great for the U.S. financial sector, but hard on main street Americans. This is a big reason we are loosing industry and manufacturing year on year. The financial sector tail wags the dog, and tariffs will remain low in order to export reserve dollars.

    At its root, money is based in the law. The law can change quickly if circumstances demand it.

  24. The Portuguese ten-year bond is composed of several components. Assuming no liquidity premium, there is a real risk-free rate, an inflation premium, and a real default risk premium. All of these are over a ten-year horizon. We can approximate the inflation premium from the difference between nominal and TIPs and similarly the real risk-free rate from TIPs and CDS, so we can be fairly confident in the levels of the risks that make up the nominal yield.

    If the real default risk rises and the inflation premium and real risk-free rate are constant, then of course the ten-year nominal yield will rise.

    However, if the real risk-free rate rises by three times the move in the default risk and the inflation premium falls, then it is by no means clear which way the nominal yield would necessarily move (depends on the relative sizes of the moves).

    What is clear is that there is not necessarily a market inefficiency based on what you said. Hence, your argument is sloppy.

  25. Again, you’re missing the whole point of the post. The point is to show that the move in CDS is not reflecting reality and that the bond market is. And when USA CDS falls to 40 in the coming 3-6 months I will be certain that you won’t come back to say you were wrong. If you’d like, we could make a friendly wager on USA CDS in the coming 6 months. If they hit 40 your analysis was wrong. If not, mine was.

    What’s actually interesting here is that you’re trying to apply some sort of efficient market analysis to this whole thing. Well, the move in CDS occurred over the course of two days when they jumped 8bps in 48 hours. That just happened to coincide with the debt ceiling vote/debate and a rise in yields of about 10 bps over the same period. So, it didn’t appear all that inefficient at first, however, the CDS prices remained firm in the ensuing few days while yields corrected.

    So, it’s a lovely thought to believe that there is some sort of efficient pricing here, but I think it’s simpler than that. Someone is betting on a soft default as credit trader said. And they’re going to be wrong. And when they are the CDS will correct back down towards the 40 level. End of story.

  26. If I had to guess I would say that it is more likely that the CDS spreads fall than rise over the next six months since I think Congress will get its act together, so to that extent we may have some middle ground.

    Before this post I didn’t have a particular view on where the CDS is going to go. The distribution of the expected returns on this bet is a bit interesting. I’d say that it would likely be a skewed distribution. It can only go down so far, but there is more room on the upside if the government is stupid. If I were to include CDS in my portfolio, I would need to account for these things and I’m not sure how it would work out. Shorting the CDS is hence risky since its like picking up a penny in front of a steam roller.

    Nevertheless, you still missed my point. There’s no such thing as a correct price and looking at one day or anothers move and divining things is fool-hearty. The most relevant question is whether there a risk-free arbitrage you could do in order bring this inefficiency back into line. I’m not sure what you would say. Can you sell CDS and buy something else and make a risk-free profit from your knowledge? No. At best, you can just bet on CDS, which is not a risk-free bet.

    Your argument is basically that the U.S. will never default, so the correct default risk premium should tend toward 0. That might be your opinion, but one person’s belief is not sufficient to claim a market is inefficient.

    If the CDS spread goes up 8bps, nominal yields go up 8bps (rather than your ten), and real risk-free yields and inflation breakevens are unchanged, then you could say the market requires greater compensation to take default risk. If nominal yields then fall back by 8bps and CDS spreads hold, it is possible that the real risk-free yields or inflation breakevens have moved in order to justify this action. If inflation breakevens were what changed, then you could directly see it in the relative T-note-TIP spread. If inflation breakevens held, this just means that for whatever reason the real risk-free rate fell. So there’s no inefficiency unless you can borrow at some different real risk-free rate to take advantage of it.

    I’m not sure how many more different ways I can explain this, but the basic conclusion is that your framework is mistaken.

  27. I think you’re trying to find an efficiency where there isn’t one. The CDS market does not correlate to your theory over long periods of time. In fact, the moves in CDS tend to be very dramatic and short in timeframe as it is a thinly traded and highly inefficient market. Just look at last summer when nominal yields and spreads declined persistently over the course of 3 months and CDS were unchanged albeit for a 3 day trading panic in August.

    The USA will not default. Yes, this is the point I am making. The CDS market does not properly account for the incredibly low risk of the USA defaulting. You might think it’s the equivalent of stepping in front of a train. I think it’s incredibly naive to believe that we will choose to default. You seem to think there is some efficiency at work here. I think the entire existence of CDS in US govt debt is an inefficiency.

    If the US govt chooses to default on debts that it can always fulfill then we’re substantially dumber than I assumed. We should just fold up shop and go live on islands in solitude. What’s the point?

  28. A rising CDS price for the US indicates that the market doesn’t believe the notion that the US can’t default. Perhaps TPC doesn’t like the notion that the US can and will default or – at least – will restructure its debt, somewhere in the future.

  29. No, today I am not. I am even “long” Treasuries and Bunds (BUXL) but this is “”for the time being””. But perhaps next month, quarter of even perhaps in 2012. We’ll have to wait and see what the graphs are telling us. Today there’re still lots of other opportunities of making a buck.