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Using derivatives and swaps to analyze the US Treasury bubble

As US Treasury rates keep dropping lower and lower and talk of a bond market bubble exacerbate, one thing that is clear is that money is flowing into government debt not because of a rise in safety but likely because of a lack of confidence in most other investment assets.

Then there is also the Japan investment factor with Japanese investors and banks more than making up for the fall in China’s investment into Treasuries. A net 2.1777 trillion yen (~US$25.6 billion) of bonds and notes were purchased by Japanese residents for the week August 8-14, 2010 – the highest on record since the Japan Ministry of Finance (MoF) started releasing the data in 2005. It marks the 14th straight week of positive Japanese investment into Treasuries going back to May of this year around the time when Naoto Kan became prime minister of Japan.

Credit default swap prices on these so-called “risk-free” assets (US government bonds) have actually increased on a percentage basis, more than the fall in yields. United States CDS prices are up 40% in August alone while 5-year Treasury yields have only fallen 15% over the same time period (from 1.64% to 1.4%).

On Wednesday, 10-year US Treasuries fell to as low 2.4157% intraday after closing at 2.50% the day before. That is the lowest level since 2.4% reached on January 20, 2009. US 30-years fell as low as 3.46%, 5-years fell as low as 1.2775% and 2-years fell to 0.4542%. As investors fear another recession and dump their money in government securities around the world, particularly in the US, the yield curve has flattened out to near record levels as investors avoid stocks and prompting worries of a bubble in government debt. The yield spread between 10-year and 2-year treasuries fell under 200 bps after closing at exactly 200 bps yesterday, which is also the flattest it has been since April 2009. Reuters reported that “The closely watched 2/10-year segment of the yield curve flattened as far as 194 basis points……The drop through 200 basis point marked a break of initial support, as did 198 basis points. The next chart support at 193.5 basis points appeared to be holding. Beyond that analysts are watching 188.5 basis points.“  USA CDS (5-year) meanwhile has risen over 40% in August alone from 35 bps at the beginning of the month to its current level around 50 bps.

In comparison, Japan CDS is actually slightly lower from around 70 bps to 65 bps over the same time frame. Signs of a bubble indeed (or at the very least technical rather than fundamental factors) when bond yields and spreads drop but credit risk does not.

Disclosure: long all stocks