USA CDS SPIKE WHILE TREASURY YIELDS HIT NEW LOW?

It’s always interesting to keep an eye on the CDS markets.  There are few markets where panic is better on display than in the credit markets – they can be illiquid, irrational and incredibly complex.  The moves can be violent, gut wrenching and often times, totally wrong.  A quick glance at the recent moves in this market is a prime example of this violent action.

In my opinion, there are few things more irrational than the existence of CDS on the USA (see Figure 1).  Okay, perhaps that is going a bit too far, but the volatility in USA CDS can often be gut wrenching and dramatic – as if the world’s largest and most dynamic economy is a mere penny stock.

(Figure 1)

It is my opinion that the odds of a true debt default in the USA are astronomically low.  Of course, the majority of investors probably disagree with me – for instance, former heads of the Fed, famous bond investors, and even Treasury Secretaries disagree with me.  Not to mention, most Americans (and most investors for that matter) believe we are on the precipice of becoming the next Greece.  Regular readers are probably familiar with my diatribe about the debt situation in the USA and why I believe there is no threat of true debt default in the USA without a serious lapse of judgment by the US Congress.  Even Mr. Bernanke (despite his faults) absolutely nailed his response to this very question by Barney Frank late last year:

Barney Frank:

“Do you think there is any realistic prospect of America defaulting on its debt in the foreseeable future?”

Bernanke:

“Not unless Congress decides not to pay which I don’t anticipate….”

But what really makes this all so interesting to me is that the USA could technically default through a hyperinflationary episode in which the USA is essentially deemed a lousy economy and an even worse overseer of its currency.  I don’t discount that there is some possibility of high inflation at some point, however, I also put the odds of this as being relatively low (my position on a grossly indebted private sector that results in deflation is well documented).

But who is right?  If the risk of inflation appears low and the USA cannot technically default on its debt then why are bond yields near record lows while CDS spike higher?  In my opinion there is a great inefficiency occurring in the markets.   Clearly, both CDS and government bonds cannot be right.  This is obviously a hotly debated topic and I would never bet against the ignorance of the US Congress therefore I understand that, like all market participants, I know less than I think I know.  It is virtually impossible to understand a system as complex as a stock market in order to make a truly risk free bet.  But the beauty, in understanding a potential inefficiency such as this and the fact that I know less than I think I know, is that there is always a hedge, always a way to protect against the risk of being wrong. Finding the inefficiency is usually the hardest part….

The macro debate is, in my opinion, the most interesting of our time.  Can the USA default?  Will we suffer hyperinflation and effectively default?  No one really knows for sure, but the inefficient market provides us with opportunities to not only hedge against potential outcomes, but to potentially profit from them.   The markets will hash this all out in due time.  Hedge accordingly.

Source: CMA