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Speaker John Boehner said, “Nobody knows what will happen if there is no deal on raising the debt ceiling. It’s a crapshoot.”

Basic CDS arbitrage should make CDS and sovereign yields move together, but this is no longer the case in the US, since the S&P’s first warning in April. We have the same pattern recently in Germany as Greece, Italy, etc. have been sinking further into the crisis. Such a divergence is not surprising for Germany as it is the main anchor of stability for the Eurozone and thus provides safety.

(Click charts to enlarge)

How can US Treasury bonds behave as a safe haven while S&P and Moody’s have decided to put US debt under review? One explanation is that a default, however short-lived (the definition of a selective default is: a country that fails to honor one or several obligations but maintains its ability to pay in the future), would trigger such global contagion risk. Could US bonds remain attractive nonetheless?
First, according to our business-cycle-based model, UST 10-year rates are just below fair value (first chart below). Rates are 10 to 20 bp below the level suggested by the economic news flow. As a default would bring the US economy into recession, the current level of rates is not at odd with this approach. Second, the problem with having a high ratio of global liquidity to World GDP is that safe haven assets are in short supply. Given the strong exposure on many risky assets, any default compounded with contagion could trigger some repatriation. The recent rebound of the USD in the wake of higher volatility provides some support to that view. As long as the downgrade is limited, the US should not lose its investor base.
Third, can the threat be considered non-credible? This could have been the case a few weeks back. As we are getting close to the deadline, the CDS/UST 10-year yield relationship reflects the growing risk of failure to reach an agreement.
Conclusion
US dollar denominated assets may suffer from a failure to breach the debt ceiling. Yet, the post-QE2 behavior of long-term rates should require a cautionary stance.
According to the “risk premium” approach, a failure to raise the debt ceiling may reduce the appetite for USD denominated assets and translate into higher yields.
Yet, the “growth risk” approach suggests that the US economy would fall back into recession (or much weaker growth). This would limit any strong upward pressure on rates.
The “safe haven” approach takes into account the huge amount of liquidity available globally and the widening gap between the supply of safe and risky assets. If, as Moody’s suggests, the default is selective/short lived, US Treasury bonds will remain attractive.
Source: Unintended Consequences of the Debt Ceiling Debate