One danger a lot of smart Washington folks have been worrying about is that investors, financial leaders, and other Wall Street bigwigs have grown so accustomed to D.C. dysfunction that they’ve been lulled into complacency about the possibility of default—when the U.S. hits the limit of its borrowing capacity in mid-October. Well, Wall Street has just woken up to that danger—and the accompanying chart proves it.
The above chart, created by Bloomberg LP’s chief economist, Michael McDonough, plots the cost of a five-year U.S. credit-default swap against the cost of a one-year swap. These credit-default swaps are basically an insurance policy for people who hold U.S. government bonds.
Let’s say you own government bonds because you consider them a safe place to park your money. But you’ve been watching the news from Washington these last few days—or maybe read the cover story in the latest issue of Bloomberg Businessweek—and suddenly you’re more concerned about the safety and value of your investment. Not concerned enough to sell the bonds—you don’t believe the U.S. will commit financial suicide by actually defaulting—but worried enough by Republican hardliners that you anticipate serious market turmoil in the weeks ahead. So you buy some credit-default swaps, which rise in value as the chance of default grows or the lender’s confidence in the credibility of a borrow wavers.
As the chart shows, the prices of both five- and one-year credit-default swaps have spiked in recent days. This reflects the “credit deterioration” presumably brought about by the congressional impasse. (That blue line is the number of Bloomberg Wire stories mentioning “government shutdown near.” It, too, has spiked.)
But there’s something else going on—something unusual. Ordinarily, the price of a five-year swap is higher than the price of a one-year swap because you’re buying a longer policy. It’s a bit hard to see in the chart, but over the last few days the price of a one-year CDS (red line) has jumped higher than the five-year CDS (pink line). It’s a little a clearer in the chart below, from my Bloomberg Terminal (where the one-year line is yellow and the five-year line is blue). This is a strong indication that investors perceive an immediate, short-term risk: default.
It looks as if the imminent shutdown has convinced people that a default—or a near-default that drives down bond prices—is more likely, and they’re responding as you’d expect, by showing signs of fear. Better late than never.