Markets hold the whip, but are they rational?

July 27, 2011

There has been a lot of discussion over the past few days about whether the United States deserves a triple-A rating. The weak and meandering attempts of the Congressional leadership and President Obama to reach a consensus on raising the debt ceiling has prompted this storm of confusion. The political theater is painful.

Most of the talk about ratings revolves around whether the level should be lowered one or more notches. But in The Telegraph today Ambrose Evans-Pritchard goes further and says it’s not really that important whether the United States retains a triple-A because the credit rating agencies don’t have the credibility to strip the rating to the world’s largest sovereign debt issuer (emphasis mine):

Yes, the US may be stripped of its AAA by Standard & Poor’s. A nice one-day story, but otherwise irrelevant. Global bond vigilantes are quite able to make their own judgement on the substantive default risk of the US. The rating agencies are out of their league on this one.

Evans-Pritchard’s statement implies that the qualitative judgments of rating agencies about default risk are less useful than the collective insight of bond-market participants. But is the market rational? The bond markets assess their view of the likelihood of default through a quantitative measures like credit-default swaps.  CDS are bought and sold between institutional investors and represent a sort of wager on whether an issuer like the United States or the state of Illinois will default on its bonds. They are a kind of insurance policy because if the issuer does default then the holder of the CDS receives payment of principal from the issuer. In other words, it’s an opinion with a whip in its hand — unlike the assessments of credit rating agencies, whose raters suffer nothing if they assigned the wrong rating.

The CDS market data provider, Markit, sent over some price levels on municipal CDS today that included a price for CDS on U.S. Treasuries. I thought it might be interesting to compare the credit rating of the US (AAA/Aaa) and the corresponding credit-default swaps (in basis points) against some heavily indebted states (see chart above).

What we see is that although the federal government has over six times the amount of debt relative to what they collect in tax revenues, they receive a AAA rating and 58 basis points on 5-year CDS. This is quite low when compared to Massachusetts, which has a AA/Aa rating (two notches below AAA) and 107 basis points on their CDS.

This beneficial treatment for the debt of the U.S. government has persisted for a number of years. The difference between the very low cost of insurance for the United States and the higher costs for the states is always explained away by saying the federal government can simply print more money; it can’t default because it has an endless money supply.

But is this true? Can the chairman of the Federal Reserve simply speed up the printing presses now? No, I think the bond vigilantes would unload their guns straight into the heart of the U.S. interest rate and send the CDS soaring.

Our elected leaders, through their dithering, are causing the bond markets to sway and leading people to challenge the old order. It seems to be left once again to the bond vigilantes to call in some debts and create some order. But let’s not assume all is perfectly rational in the bond markets. They can hold onto old assumptions and dither, too.

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