Bond market warns of new financial crisis

Out of the dark and murky world of sovereign credit protection, a warning light flashes red

By Anthony Mirhaydari Nov 20, 2009 8:03PM

MirhaydariGovernments around the world unleashed Keynesian-style stimulus in an effort to kick start their economies. And as expected, tax revenues plummeted while fiscal deficits soared.

 

Here in the United States, the deficit for fiscal 2009 came in at $1.4 trillion or 9.9% of GDP -- the highest since 1945. Among the OECD nations, the deficit is expected to peak at 8.2% of GDP in 2010. President Obama tried to head off  criticism this week by recognizing that indiscriminately adding to the national debt could undermine the nascent recovery.

 

It was always a race against time: Borrow and spend to get the economy growing again before the vigilantes in the bond market revolt, drive up interest rates, and force a cut in spending and an increase in taxes. For awhile, it worked. Interest rates fell. Government funds bolstered the economy via "cash-for-clunkers" and the homeowner tax rebate.

 

But now, unfortunately, it appears the bond rebellion has begun.

 

The early warnings 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 NYSE.  It is here that credit default swaps or "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. Klein's Government Risk Index, based on the CDS of seven different countries, has increased 32% since October.

 

Japan CDS


The main cause has jump in the cost of protection against Japanese, British, and American debt. Japanese CDS doubled from September 11, 2009 to November 9, 2009 (see chart). This has helped push Tokyo's Nikkei Average down nearly 10% as stock investors responded to the vote of no confidence.

 

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 OECD.

 

Nikkei

 

This could set the stage for a risk 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.

 

In his words: "[A] continued rise in the GRI is an early warning sign that market participants expect a stall in global economic recovery and we would expect corporate credit (and equities) to deteriorate.  An even-wider GRI in December would be a grim portent for 2010."

 

I'll keep you posted.

 

Disclosure: The author does not own or control a position in any of the funds or companies mentioned.

 

Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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