The last 4 days have seen the price of protection against a default on US Treasuries spike by the most in 4 years. While USA CDS trade on both a default and devaluation basis (as well as technical issues related to which Treasury is cheapest to deliver) this spike to 5-month highs (from what was extremely high levels of complacency) is very notable in light of today's Kocherlakota "whatever it takes" speech. While still well off 2011's debt ceiling debacle panic highs, this move does suggest more than just the politicians are worried about a technical default occurring on US debt. By way of comparison, Germany trades at 23bps and Japan at 61bps against USA's 32bps.
And while the risk of a US default is virtually non-existent (will Benmosche's AIG make whole the buyers of US CDS when America is broke? good luck) and certainly will be preceded by literal paradropping of US currency from the Fed's own private fleet of helicopters, there is a simple pair trade for those who would like to position for a contentious debt ceiling fight with an ETA mid-October and skip the bipolar and HFT-dominated equity markets. Recall that in the summer of 2011 when the last big debt ceiling debacle loomed and resulted in a last minute outcome that also led to the downgrade of the US by a rating agency that has since sold out, rates of bills due just before the debt ceiling D-Date soared, while those sufficiently after the ceiling interval tightened. Well, the same trade is just as applicable this time.
Credit Suisse explains:
Sell October 31 Bills versus 12 Month Bills
Supply dynamics and potential market concerns around a debt ceiling stand-off in Washington should push the 1M1Y bill curve flatter. Given our expectation that Treasury will run out of room on October 24, the October 31 bills are likely the most vulnerable, and should cheapen significantly versus 12 month bills in a protracted fight.
One-month and three month bills are already trading close to zero, having briefly traded negative last week. With bill supply to remain flat heading into the end of October, suggesting that supply should keep bills yields across the curve under pressure. With bill yields largely beholden to supply dynamics, the greatest scope for further compression is in year bills, which are currently trading around 10bp. Given historical relationship between bills yields and bills outstanding, year bills are roughly 3bp rich to supply-implied fair value, while 3-month bills are about 3.5bp rich.
This trade may be difficult to put on in size until after quarter end due to dealers balance sheet constraints. But as noted above, we believe that the market will not begin to fully price the risk to front end bills until about two weeks before the end date. We expect the opportunity to remain available at for the first week of October.
The 2011 debt ceiling brinksmanship impacted securities with some type of payments around the date that Treasury had circled as the last day. While the effect resonated out the bill curve, it reached its extreme in the early August bills, with the August 4 and 11 bills trading at 25bp at the end of July (when one month bills were trading at 17bp and year bills were at 20bp).
The level of 1m rates alone suggest a near-term flattening bias—when 1m bills are trading at or below 1bp, the 1m1y curve has flattened at least 0.5bp over following week 55% of the time, while steepening more than 0.5bp just 31% of the time. On average, the 1m1y curve has had a very modest flattening tendency since 2009, but not to the extent seen when bill yields are close to zero.
The last go-round, the 1m1y curve flattened to 3bp. Though the curve is just 6bp away from that right now, it is beginning from a starting point that is 10bp flatter than one month prior to the 2011 debt ceiling. The securities that the market viewed as “at risk” traded with yields above year bills, hence our recommendation to sell the October 31 issue rather than the current one month bills.
We think that the curve has scope to flatten to zero, if not further, depending on how close to the wire negotiations come. The risk to this is that the curve steepens should an earlier than anticipated deal allow Treasury to boost bill supply sufficiently to push year bills substantially cheaper while the short-bills continue to roll down to (or remain at) zero.