Thursday, July 21, 2011

Wall St. Is Worried About Default, But Still Expects a Deal

. Thursday, July 21, 2011

CDS on Treasuries have more than doubled in the past two months. And that's not all:

On Wall Street, Treasuries function like a currency, and investors often use these bonds, which are supposed to be virtually fail-proof, as security deposits in their trading in the markets. Now, banks are sifting through their holdings and their customers’ holdings to determine if these security deposits will retain their value. In addition, mutual funds — which own billions of dollars in Treasuries — are working on presentations to persuade their boards that they can hold the bonds even if the government debt is downgraded. And hedge funds are stockpiling cash so they can buy up United States debt if other investors flee. ...

Volatility in stocks has soared, and some investors say stock prices are falling because a United States default could severely raise companies’ costs of doing business.

In the Treasury market, investors are starting to sell, fearing that the government will not make good on some interest payments that will be due next month. And complex financial instruments that will pay out if the United States defaults have become twice as expensive to buy as they were at the start of the year. ...

“The metaphor is a pile of sand,” said Mark Zandi, the chief economist at Moody’s Analytics. “You keep putting one piece of sand on the pile, nothing happens, and then, all of the sudden it just caves.”

I will say that I'm surprised that the market reactions haven't been stronger. I still believe (mostly without evidence) that the markets expect a deal to get down, as do I. As I write this, the top headline on most news websites is that Obama and Boehner are close to a deal, and the markets are up big. Of course I don't want to read too much into that, but look at the betting markets. Right now, Intrade has the chance that Congress passes a deal before midnight on July 31 at only 39%, but the odds that Congress passes a deal before midnight on August 31 at 72%. Remember that the deadline for avoiding default is August 2. So betting markets seem to expect a deal in the 11th hour, which is also what I expect.

I still worry about the trembling hand, however.


Wall St. Is Worried About Default, But Still Expects a Deal
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