Shorting U.S. Government Risk

In the hustle and bustle of the new consumer-loan bailout announcement by Henry Paulson and the Barack Obama press conference, the capital markets have largely ignored what could turn into a seismic shift in debt, and perhaps equity, pricing fundamentals within the first half of 2009. Shortly after the two podium flourishes, spreads for 5-year credit default swaps on US treasury credit widened to 49 basis points (from 43 bps late Monday); 10-year spreads are being quoted around 52 basis points with limited buying interest.

On Monday, following Alistair Darling’s confirmation that the British government will need to issue a total of $225 billion worth of gilts in this fiscal year, CDS spreads for 5-year UK sovereign risk briefly breached 90 basis points. Chancellor of the Exchequer Darling detailed a multi-faceted stimulus package to help the UK economy weather what is expected to the worst recession in decades.

Commenting on the Goldman Sachs (GS) $5 billion bond issue on Tuesday, Cabot Money Management’s William Larkin said that “there is a lot of demand for risk-free investment and this fills the void a little bit.” The fact that the markets are now treating an effective yield of 3.37% as a “risk-free” rate within the framework of today’s yield curve speaks volumes for future perceptions of US government risk; November 2011 treasuries traded at 1.75% late Tuesday.

A statement made in Market Folly’s post on Seeking Alpha ("Shorting Treasuries: What's the Rationale?", November 13, 2008) sets the tone for the next few weeks: "Make no mistake about: There will be enough US Treasury Bonds to choke on, as the government tries to finance this debt.” Since that post, the bailouts and guarantee commitments have multiplied, and Market Folly’s conclusion might well qualify as a classic understatement today. In the months to follow, we will see hundreds of billions of dollars of treasury borrowings, tens of billions of dollars of debt backed by FDIC guarantees and, pursuant to Secretary Paulson’s announcement today, hundreds of billions of consumer loan securitizations carrying the full faith and credit of the US government.

There is every reason to predict that CDS spreads on US credit will move into the 70-90 bps territory, perhaps as early as the first quarter of 2009. And sooner rather than later, that growing default risk will start creeping into the yield curve. For the record, this writer, based on targeted CDS spreads above 120 basis points, is seeking compelling profits on 5-year and 10-year maturities, prior to the end of the second or third quarter of next year.

Arguably, outright short treasury positions at this juncture are subject to threat from lower Fed Fund rates, and a related lowering of the yield curve matrix; but that risk is minimal, particularly after the price recent declines in short-treasury ETFs (PST, TBT and RYJUX) and after OIS (overnight-indexed-swap) rates dipped appreciably below 0.50%. Risk neutral investors may consider ETFs which deal in short-dated treasuries.

It is possible that the sheer depth and extent of the domestic and global recession will force the Fed to keep the short end of the yield curve around the zero level. So look for the slope to gradually sharpen primarily due to deteriorating credit quality, an event which has no precedence whatsoever; in view of the overload of contradictory data governing the period between 1928 and 1934, this writer is not drawing any parallels with the Great Depression.

After Goldman Sachs, General Electric (GE), Citigroup (C), Bank of America (BAC), Morgan Stanley (MS) and JP Morgan (JPM) are all lining up to sell FDIC-backed bonds. The effective yield on these bonds is certain to create further confusion amongst debt traders, particularly European and Asian dealers who are already busy trying to figure out why American sovereign risk is being priced along several layers.

One specific, and important, question is out there in the marketplace today: Did the 300-odd investors who placed buy orders for the Goldman Sachs bonds make provisions for 5-year CDS spreads on treasuries, in part or whole?

Disclosure: Author holds short positions in PST, TBT

Comments

[apppro:]

I find that just a mention of shorting anything that has to do with our society as a whole at this point in time - Deplorable! Just deplorable!
When is enough enough?

2008 Nov 26 07:13 AM

[TexM3:]

Appro, that’s stupid. What you should find deplorable is what our government is doing with your money, and destroying free markets. If you have the foresight and risk tolerance why not try to profit and add to you cash for the hard time ahead?

2008 Nov 26 07:44 AM

[apppro:]

TexM3, that's deplorable. What you should find stupid is how we let a few people destroy our confidence and economy by allowing such blatant rumor-mongering, naked shorting, and gangshorts; and NOT done anything about it.
I am so happy that you have been able to bet against everyone so successfully.

2008 Nov 26 08:10 AM

[TexM3:]

Rumormongering, the “rumors” are true!!! Why should we have confidence in our economy its been destroyed. Go ahead and skip along in ignorant bliss, or put your head back in the sand. I’m going to make money.

2008 Nov 26 09:09 AM

[dkp:]

Those who are buying CDS on US treasuries, do they really believe that their counterparties will honor their
commitmrnts whren the US itself has failed? They would have been buried long before the death of US Treasury.

The stupidity of the CDS market becomes evident when you consider that the government can always give you cheque in USD to repay its debt..What would you do with that cheque? Deposit in your bank account and put
the amount in the hands of treasury via your bank.

Buy the CDS treasury and you buy snake oil. How clever!

2008 Nov 26 09:42 AM

[random2348:]

dkp,

Note that credit default swaps on Treasuries are quoted in Euros. See

www.bloomberg.com/apps...

It is not necessarily the case that one's counterparty has failed when the U.S. has failed. In particular, a counterparty not based in the U.S. might not have failed at the time of a U.S. government debt crisis.

Credit default swaps on Iceland's debt - also snake oil? They can always print more krona to repay their debts, right?

The CDS market is saying that the probability of the U.S. defaulting on its debt is very small but non-zero.

2008 Nov 26 10:07 AM

[random2348:]

apppro,

If confidence returns to the stock market and the credit markets, then Treasuries are likely to sell off. To some degree, shorting Treasuries is a bet that financial markets will normalize and risk aversion will decline. But it is also bet that stands to gain if the U.S. government issues such a massive amount of debt in order to finance the bailouts that the new supply of Treasuries overwhelms the flight-to-safety demand.

2008 Nov 26 10:16 AM

[dkp:]

Iceland's debt was in foregn currency, it could not print dollars. Treasury's debt is in domestic currency.

2008 Nov 26 10:18 AM

[random2348:]

dkp,

OK - bad example. How about this one, then? en.wikipedia.org/wiki/...

"Russia's ruble-denominated debt would be restructured in a manner to be announced at a later date"

2008 Nov 26 10:35 AM

[soonerxii:]

That's a pretty good post. It is really kind of ignorant to blame short sellers for any of this mess. Why does no one blame the pumpers who thought that stocks should only go up? Or even the real culprit....Alan Greenspan.

Greenspan's Bubbles is a great book for understanding how we got to where we are today.


On Nov 26 10:16 AM random2348 wrote:

> apppro,
>
> If confidence returns to the stock market and the credit markets,
> then Treasuries are likely to sell off. To some degree, shorting
> Treasuries is a bet that financial markets will normalize and risk
> aversion will decline. But it is also bet that stands to gain if
> the U.S. government issues such a massive amount of debt in order
> to finance the bailouts that the new supply of Treasuries overwhelms
> the flight-to-safety demand.

2008 Nov 26 10:36 AM

[random2348:]

Let me stress that I believe that it is very unlikely that the U.S. will ever default on its debt (maybe "default" is too strong of a word - yes, the U.S. can always print more dollars - let's say "restructure" instead - and by "restructure" I mean changing the terms of its obligations in a way that is akin to default, not merely adjusting the mix of bills, notes, and bonds). Until recently, the conventional wisdom was that for the U.S. to have to restructure its debt would be basically impossible - even now, if someone asks you for "risk-free rates," you're probably going to look up Treasury yields. Well, maybe a future debt crisis that results in a restructuring is not impossible, but just very unlikely. Note that foreign governments would bear much (but not all) of the pain of a restructuring.

2008 Nov 26 10:59 AM

[sbenard:]

This article underscores a growing concern that U.S. government debt is unsustainable. It is the Mother of all Bubbles! When it pops, mayhem will be an understatement!

2008 Nov 26 01:11 PM

[zanardm:]

The Fed is out of control. It has turned into a debt ('quantitative easing') machine. The T-market will turn. Dead cat bounce dollar - here we come.

2008 Nov 27 10:37 PM