Friday, May 27, 2011

U.S. at Risk of Default as Cost to Insure U.S. “Ponzi Scheme” Against Default Rises Sharply

by Mark Obyrne  ~ GoldCore Limited ~ GoldSeek.com
Gold and silver are lower today with profit taking, Chinese bond buying and increased risk appetite being cited for the price falls. Gold is marginally lower in all currencies and is 0.2% lower in U.S. dollar terms despite the dollar coming under selling pressure again this morning. Risky assets have recovered somewhat from recent losses with Asian and European equities and commodities receiving a bid.


Cross Currency Rates

Reports of China buying Eurozone government debt may have led to a rise in the euro and equities. However, the scale of sovereign debt risk internationally is such that even significant and ongoing Chinese buying would be unlikely to contain the crisis.

Sovereign debt risks in Europe and internationally continue to threaten the increasingly fragile economic recovery.

While most of the focus has been on Greece and Eurozone sovereign debt issues, the not insignificant risk posed by a U.S. sovereign debt crisis increases by the day. The risk of a US default continues to rise which can be seen in the sharply increased cost to insure U.S. sovereign debt.

Risk of a U.S. default can be seen in the credit default swap (CDS) market. 
1 year U.S. CDS has risen from 23 to 37 or by 60% in the last six trading days (see chart below). According to this measure, the U.S. is now more likely to default than Slovenia and Indonesia in the next year.
US CDS 1 Year – 3 Month Duration – US (brown), Japan (Yellow), UK (Purple)

In the more liquid 5 year U.S. CDS, the cost to insure has risen by some 50% in the last week. The U.S. is considered more likely to default in 5 years time than South Africa, Malaysia, Panama, Brazil and Colombia.

Credit default swaps on U.S. debt saw a flutter of activity in the past week with investors placing 135 trades in U.S. CDS in the week ended May 20, far above previous weeks, when in some cases only one contract trade was seen.
This compares to 360 CDS trades in the week on Spain's sovereign debt, 191 on Greece, 142 on Portugal and 136 on Italy.
Volumes in U.S. CDS have been ticking up, though at about $4 billion they remain significantly lower than the $9 trillion in outstanding U.S. Treasuries.

The squabbling between Democrats and Republicans last week as the U.S. debt ceiling of $14.3 trillion was being reached did not help sentiment towards U.S. debt.


Gold Bullion in US Dollars – 30 Days (Tick)

Nor did former Soros’ partner Stanley Druckenmiller, the billionaire former-hedge fund manager and legendary investor, comment in the Wall Street Journal that the Federal Reserve’s bond purchases are a fraud and a “Ponzi scheme”.
He advocated a U.S. default or a technical default, saying “"technical default would be horrible, but I don't think it's going to be the end of the world. It's not going to be catastrophic."

Credit default swaps are far from a perfect way to establish credit worthiness and risk of default of countries. However, it is arguable that quantitative easing and governments internationally, including the US, electronically creating money in order to buy huge tranches of newly created government debt has significantly distorted the government debt markets. Thus, record low yields are artificial and are not a good way of measuring fiscal and monetary risk.

The market manipulation that is QE1, QE2 (and possibly QE3, QE4 etc.) has completely distorted the free market in U.S. government debt and indeed all capital markets. It has led to artificially low interest rates in the US and internationally.

It has been successful in the short term in keeping yields low but short term panaceas have a habit of becoming long term illnesses.

While a US default would not be “catastrophic” it would likely lead to a very sharp fall in the U.S. dollar, (especially versus the hard currency, collateral and monetary asset that is gold), sharp fall in U.S. bonds and sharply higher interest rates.

This has the potential to create another systemic crisis involving sovereign nations and banks globally and could lead to a deep recession, a Depression and in a worst case scenario - hyperinflation

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