How to tell you’re not Greece — yet

By Rob Cox
April 12, 2010

By Rob Cox and Agnes T. Crane

Greece may be enviable as the ancient cradle of democracy — but no country wants to emulate its contemporary fiscal troubles.

Markets are exacting a heavy price for the Hellenic Republic’s budget woes. Yet the Mediterranean archipelago is hardly the only country that would fall into crisis if creditors lost faith. Indeed, the government of the United States is running a deficit of Greek proportions, although its total debt load is much less frightening.

A spike this past week in the yield on U.S. government debt — the benchmark 10 year Treasury yield hit 4 percent — ignited fears over the creditworthiness of the world’s largest economy. Those faded when investors piled in to the next bond auction, pushing the yield back down by 0.1 percentage point.

Bond yields, and the cost of financing they imply, are an important gauge of the pressure in financial markets. Leaders of highly-indebted countries need to watch them closely. But there are other signs. Herewith, a dashboard for America’s financial stewards:

Credit Default Swaps — The idea that the United States would ever default on its debts used to seem absurd. But years of big deficits and the gargantuan government rescue of the financial system during the credit crisis have introduced some doubts, while the development of a lively market in sovereign debt credit default swaps has made it possible for investors to put money behind their views.

America’s CDS reached an all-time high along with the crisis in March of 2009, when investors had to pay $100,000 to insure $10 million of Treasuries. The going rate has dropped to around $41,000. That pales in comparison to over $400,000 for similar Greek protection. On this front, the United States still looks far from Greek.

Currencies — When investors lose confidence in a nation, its legal tender feels the sting. The euro has taken a pounding, thanks to the troubles of the euro zone’s most troubled member. It’s down about 6 percent against the dollar and against the yen since the beginning of the year. The euro’s losses are clearly the dollar’s gain, but the buck has also climbed 4 percent against a broader basket of currencies. On this score, too, the market is signalling that Washington is a far cry from Athens.

Stocks — Equity markets are good rough indicators of how investors look at a country’s prospects — the productivity of its enterprises and the health of its financial system. Greece’s stock market, unsurprisingly, is on the ropes. It’s down 10 percent on the year while the DAX of more creditworthy Germany is up 5 percent. The S&P 500 has gained 7 percent since the beginning of the year. That’s a sign investors in U.S. stocks aren’t worried.

Options Volatility — Options on stock market volatility can be an even more sensitive indicator of fear than the market itself. The Chicago Board Options Exchange Volatility Index, which is a measure of expected swings in the S&P 500, is sometimes called the “fear index”. Right now it is exhibiting more calm than fright. On Friday it stood at around 16, below its level in August 2008. Of course, that low was followed by a huge economic and financial storm.

Bond yields, CDS spreads, currency strength, stock markets and options volatility: none of these market measures in isolation provides a significant read on the state of sovereign finances — of the United States or anywhere else. Taken as a whole, though, they provide a good read on the perceptions of the widest possible swath of investors in credit, equity, derivatives and currency markets.

Right now these altimeters of American financial health are not flashing red, orange or even yellow. But they are more current than leading indicators. It might not take much for sentiment to shift. Any sign the U.S. government is not taking seriously its need to reduce the deficit, perhaps by embarking on another stimulus plan, could tip any of these indicators into danger zones.

As Lawrence Summers, who heads the White House’s National Economic Council, said in a speech earlier this week, the ability of great nations “to mobilize to solve problems before they are absolutely imminent crises is what determines their longevity.” This market dashboard may be a useful way to mark that progress.

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