Signs Of Trouble From The Credit Market

The highest deficit to GDP ratio since 1945 is encouraging traders to buy insurance against government bonds in the form of credit default swaps. Another troubling sign is the short-term US Treasury yields moving into negative territory. Jon D. Markman from Money Morning discusses why this could mean trouble for the financial system.

There is some interesting action unfolding in the dark corners of the credit market.

Although this exploratory sojourn takes us fairly far afield from our regular stomping grounds in the equity markets, it could have important implications for our investments. So grab a thinking cap, and let’s go exploring.

First, let’s have some context. As you know, governments around the world have unleashed tons of stimulus spending over the last year. Against a recessionary backdrop, it’s no surprise that tax revenue has plummeted while fiscal deficits have soared.

Here in the United States, the deficit for fiscal 2009 came in at $1.4 trillion, or 9.9% of gross domestic product (GDP) – the highest since 1945.

It was always a race against time: Borrow and spend to get the economy growing again before the vigilantes in the bond market revolt and force a cut in spending and an increase in taxes.

It seemed to work for a while. Interest rates fell. Government funds bolstered the economy via “Cash-for-Clunkers” and the $8,000 tax rebate for first-time homebuyers.

Now, unfortunately, trouble is brewing. The first early warning comes from the credit derivatives market. This is the Wild West of financial markets – fast-growing, unregulated, and not tied to organized exchange like the Big Board (NYSE). It is here that credit default swaps (CDS) trade. These are basically insurance contracts that protect against the failure of bond issuers to pay up.

One segment of this market protects sovereign or government debt. And according to David Klein at Credit Derivatives Research, traders in this market are buying up protection at a rate not seen since July, ending four month of relative tranquility. His Government Risk Index, based on the CDS of seven different countries, has increased 32% since October.

The main cause was a jump in the cost of protection against Japanese, British, and American debt. Japanese CDS doubled from Sept. 11 to Nov. 9. These are the laggards, and the bond rebels are starting to punish them. All three countries are projected to maintain deficit-to-GDP levels in excess of 8% through 2011 according to the Organization of Economic Cooperation and Development (OECD).

This could set the stage for another panic not unlike last fall’s credit crisis. Then, financial CDS spiked and pulled the fixed-income and equity markets down with it. If the rising trend in sovereign CDS continues, Klein believes we should interpret this as the market preparing for a rise in the general risk level.

The second problem was the decline in short-term U.S. Treasury yields this week: Demand for T-bills maturing in early 2010 moved into negative territory for the first time since the depths of last fall’s financial crisis. This is an extraordinary event. Someone is betting with large sums of money that it makes sense to pay the U.S. government to hold their money for 90 days. Anytime people are willing to accept negative returns for the comfort of getting their money back in three months time, risk aversion is obviously on the rise.

Now don’t get me wrong. The context for this outlook is few clouds forming on the horizon. Sure, it could be a big tropical storm coming in. Or it could just be some innocent clouds that block the sun for a few minutes before passing on.

Just because someone is making these bets does not mean they are right – far from, in fact. For now, the sun is still shining and it’s not raining. I’ll continue to monitor these developments and let you know if and when it’s time to take action.

Another interpretation of the sovereign CDS issue comes courtesy of WJB Capital Group Inc. Chief Market Strategist Brian F. Reynolds, who has a great record of calling these things and has been much more bullish than CDR’s Klein in the past eight months.

Reynolds believes the credit bears who targeted the CDS of companies in the spring have moved to U.S. CDS to try to get a rout rolling. Credit products are a relatively inexpensive market to try and manipulate, so this is certainly possible. But he thinks that they will fail, and their short-covering will provide the fuel for the next leg up in the credit and equity markets.

Reynolds was very emphatic last year in insisting that credit bears were right, and he helped keep us out trouble by providing a guidebook to the twisted and dark world of debt. He is now equally emphatic this year in insisting that the credit bears are now only mounting a rear-guard action as prior profits have slipped away, and do not have history or the odds in their favor.

Here’s the bottom line: Credit is where the big boys play, and that’s why we need to keep an eye on this realm. The bad guys are trying to make mischief, but for now they are being held off.

If that changes, I’ll let you know.

This post has been republished from Money Morning, an investment news and analysis site.