2:54pm

Tue July 26, 2011
Economy

On U.S. Debt, An Early-Warning Indicator Flashes Red

A week from now, the U.S. Treasury may default on some debts as it hits against a $14.3-trillion debt ceiling.

Despite that once-unthinkable possibility, financial markets appear calm. The stock market has not crashed and interest rates have held steady.

Still, one indicator is showing investors are getting nervous: the cost of insuring U.S. government debt against default is starting to spike.

"It's an early-warning indicator," says Otis C. Casey III, director of credit research for Markit Group Ltd., a London-based financial information services company.

Credit default swaps, or CDS, can be used to insure investments, such as purchases of Treasury securities. The cost of such insurance has been rising dramatically in recent weeks. As of Monday, a one-year insurance contract was roughly 10 times as expensive as in April (see chart below), bringing it back to the same as in early 2009, during the worst of the Great Recession.

"It's good to have something that is sensitive enough to help tell us what's coming next," Casey says.

And CDS data suggest that unless Congress acts quickly to either slash spending or increase the U.S. Treasury's borrowing authority, what's coming next won't be good. It points to higher interest rates and unwanted volatility.

Casey says that so far, the debt-ceiling drama has not caused much financial turmoil because global investors still believe Congress and President Obama will reach a deal to raise the debt ceiling before next week.

If global investors were truly worried about a U.S. default, they would be demanding far more reward for the new risks they are taking. In other words, they would be demanding higher interest-payment promises from the U.S. Treasury in exchange for buying its securities. But in fact, interest rates have been holding steady — a sign of confidence.

A Safe Haven

Casey said that's because the United States has an ace up its sleeve — the debt of other countries may be even riskier. Looking at the huge debt problem in Europe, most investors still view the United States as a safe haven.

"Europe is worse," he says. "There just aren't a lot of safe-haven assets in the world."

As a result, investors have continued to pour cash into gold and U.S. securities. And that investing strategy has created an appearance of normality.

But Casey says the CDS market shows a "peculiar" pattern that could be worrisome. He explains it this way:

Usually, buying credit-default insurance for five years is more expensive than doing it for one year. That's because the risk is greater; more can go wrong over five years than in just one. But at the moment, that pattern has switched.

Casey says that as of Monday, the cost of five-year insurance was about 24 percent cheaper than one-year insurance.

The price inversion suggests fears about what will happen in coming weeks are rising.

"To see the one-year CDS trade at more than the five-year is peculiar," he says.

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