Two signs Wall Street is starting to believe in default

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First: the price of credit default swaps (CDS) against US treasuries has spiked. And very, very unusually, the price of a one year CDS is now higher than the price of a five year CDS.

Second: the stock market AND the bond market are down today. It is fairly common for investors to rotate from one into the other depending on outlook. When both are down sharply, as is happening today, it means investors are selling everything and keeping their money as money. That is - Wall Street is starting to put their investment money under their mattress.

Some of you may be looking at that chart and thinking "Some of those indices are up, not down". The prices quoted for treasury bonds is the yield, which is the effective interest rate. When the yield goes up on a bond, that means the price of the bond has gone down. It helps if you think of a bond as a promise to pay X dollars every year. If a bond has a yield of 4%, that means I give you $100, and every year for the life of the bond you give me $4. At the end of the life of the bond, you give me back my $100. If instead of giving you $100 I give you $99, the yield on the bond is 100/99*4=4.04%.

This chart from NPR shows the time history of the US Treasury CDS price.

As may be seen, the price paid to insure against default has gone up by a factor of 6 since January, and has more than doubled in July.

This matters for several reasons. First, it suggests that at least some of the big money is protected against default - but since the party on the other side of the CDS is likely also big money, that's a wash. Secondly, the guys on Wall Street have intelligence that makes the CIA look like amateur hour for things that affect their wealth, so this is a very nice synopsis of the best insider information in one handy number.

Once upon a time the default result of a financial panic was called a "flight to quality" - sell stocks and corporate bonds, buy US treasuries ... It will be years or decades before that image can be restored.

Also worth noting - US treasuries are sold at auction. No one wants to pay full price for something that is dropping in value like a rock. This will require this week's treasury auctions to sell more bonds to achieve the same level of cash for the government.

http://www.dailykos.com/story/2011/07/27/999498/-Two-signs-Wall-Street-is-starting-to-believe-in-default

[Usui Takumi 1,562]

When I saw the GOP bill collapse from within...thats when I started to believe in default. I think the odds are now even for a default.

[웃 910]

AAPL = $404.50 hit yesterday (all-time high)

BIDU = $165.96 hit yesterday (all-time high) <---did a 10-1 reverse split a while back...technically hit $1,650.96

AMZN = $227.20 hit today (all-time high)

Does this mean anything? Probably not but thought I would point it out...

[scandal 951]

Also worth noting - US treasuries are sold at auction. No one wants to pay full price for something that is dropping in value like a rock. This will require this week's treasury auctions to sell more bonds to achieve the same level of cash for the government.

That's not quite accurate. What is meant is that in order to attract buyers at auction, the bonds will be sold with more attractive yields. However the same face (principal) amount of bonds will be sold, not "more bonds". E.g. on Aug 9 there is an auction for 3 Year notes (you can see the auction calendar here).The 3-year is currently yielding 0.71% (as seen here). If by Aug 9 we are in a treasury crisis, and they want to sell, say, $10 billion in new bonds, then the only variable is how much higher than 0.71% yield they'll need to offer to unload that $10 billion on investors. In a small uptick, it might be 0.75%. In a serious destabilizing move it could be much much more. If so, then all other outstanding treasury bonds that are in circulation with a comparable 3 year till maturity will need to match that new yield, thereby lowering the value of those bonds for their holders. Hence, a "crash" in the bond market.

By the way, in addition to CDS prices ticking up, another sign of stress in the markets is the VIXvolatility index which is pushing higher in the last week.