What message is the CDS market sending us?

August 24, 2011

By Laurence Copeland. The opinions expressed are his own.

Not many people seem to have noticed, but something almost unthinkable has happened in the Credit Default Swap (CDS) market recently. It is now one point cheaper to insure against a default by Her Majesty’s Government than by the Federal Republic of Germany. Given that only a few months ago, Markit was quoting twice as much to insure against a default on gilts as on bunds, this is a major change – but what is it telling us?

The message is unclear, but my guess is it is not quite the one which Britain’s Chancellor, quite reasonably from his point of view, would have us believe. Yes, the market has faith in our ability and willingness to repay – but that is far from the whole story.

The hint is in the fact that Japan (with its enormous government debt, even before it gets very far with post-tsunami reconstruction) and post-downgrade USA also have low CDS rates. As I have pointed out many times before in these blogs, what we have in common with Japan and America, apart from rockbottom government bond yields and associated low CDS rates, is the freedom to print our own currency. The fact that the three of us have massive debt burdens is therefore regarded as irrelevant. By contrast, this freedom is denied to euro zone countries, who are supposed to repay debt out of government revenue, which makes their creditworthiness dependent on their ability to collect tax and their prospective future growth rates which will determine the size of their tax base. Although Germany has a reasonably modest debt-to-GDP ratio, it cannot straightforwardly print money to repay its creditors. Add to that the fact that the market is finally waking up to the realisation that Germany is coming under heavy pressure to shoulder the debt of the rest of the euro zone, and its debt level suddenly seems far less modest.

It is often said that the markets can only concentrate on one thing at a time, which seems strange – but how else to interpret the current state of affairs? How else can one explain the willingness of the market to lend unlimited amounts to America even though the Fed has made it plain that it will carry on printing money until inflation revives and the dollar gets even weaker? It certainly makes sense for investors to ignore the negligible risk of a CDS-triggering default by Britain or America – but leaving aside CDS rates, even if outright default is ruled out, why would anyone want to buy five-year gilts or U.S. Treasuries at yields of barely 1 percent?

In fact, one could ask something similar about German interest rates – unless it decides to walk away from its supposed responsibility to carry the rest of the euro zone on its back, it will end up using its overwhelming influence to force the ECB to print euros so as to support its own bond markets, weakening the euro zone in the process. But again, it is hard to imagine Germany actually defaulting – why would it, when it has enough clout to control the ECB, especially as if it ever started demanding easier money, it would be pushing in the same direction as the majority of other members (ClubMed plus France, at the very least)?

The only interpretation I can think of is that the markets foresee Japanese-style stagnation for more or less all of us in the Western world – in other words, years of slow growth or no-growth in GDP and consumption, with consequently high unemployment, against a background of low or falling prices for equities and real estate – and, of course, near-zero interest rates and inflation, maybe even deflation.

If this is the future, a 1 percent or 2 percent riskless return looks attractive – but is it what’s in store for us?

I doubt it. Apart from the fact that UK inflation, though dead according to the Bank of England, still refuses to lie down, there are other inconsistencies in this scenario.

Japan’s problem, before its bubble burst at the end of the 1980s and ever since, has been underconsumption, as evidenced by its long run current account surplus and strong – often too strong – exchange rate. As long as Mrs Watanabe kept control of the family purse-strings, Japanese (and foreigners) cheerfully snapped up all the Yen printed, with the result that the Bank of Japan found its efforts to generate inflation were like pushing on a string. Worse still, the more prices fell, the greater the incentive to hang on to Yen and to delay spending, secure in the knowledge that a new car or house was only going to be cheaper next year, so that the whole process became a self-sustaining downward spiral.

Now, there are at least two reasons why I cannot believe this scenario will be replayed on both sides of the Atlantic, or even in Europe. First of all, Mr and Mrs Smith are not Mrs Watanabe. If credit is available, they will spend. The difficult thing is to get them to save and to invest in something more productive than housing – in other words, how to reorient our economies towards investment and production and away from consumption, the opposite of the Japanese problem. In the medium term, we require a fall in the value of the pound and the dollar – which has already happened to a considerable extent. Hence the second difference between Japan and the rest of the industrialised world – we cannot all suffer simultaneously from the problem of an overvalued currency.

There is one remaining boulder blocking the inflation exit route. China’s fixed exchange rate policy was the vital link in the chain of events that led from irresponsible U.S. monetary policy to the asset price bubble, which duly burst in 2008 and got us all into this mess, and it remains an obstacle to recovery. If the RMB were allowed freely to float upward, the world economy could start to rebalance. Chinese consumers would spend a higher proportion of their disposable incomes, buying more imported goods and persuading some of its exporters to divert output to their domestic markets, while the opposite would happen in the U.S. and UK. Moreover, revaluation would also give the world economy an inflationary boost, reducing the real value of our debts, though this benefit might be offset to a considerable extent by the rise in interest rates caused by a Chinese withdrawal from the U.S. Treasury market.

Without a Chinese revaluation, the flood of dollars coming out of the Fed ends up simply inflating the price of gold and real estate in Greater China (which nowadays includes some of the smarter parts of London), a process which risks creating big problems for us all in the not-so-distant future.

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