CDS

With the possibility of a US government default growing day by day (1Y USA CDS rose 12bps today to 72bps) amid impasse after impasse in DC, Bloomberg's Mike McKee looks at the five possible scenarios should the debt ceiling be breached (however unlikely and ridiculous some may appear). From prioritization of payments to across-the-board cuts, 14th amendment interventions and delaying payments, McKee explains the process and implications of each. There are no good options left but we can't help but get the sense the Republicans might just be playing a longer-game here to take us beyond the Democrats' "red-line" of October 17th to highlight their fear-mongering (remember the shut-down devastation?) and potentially regain some election capital (in this increasingly twisted game of picking the worst of two evils)... and indeed, as we have long argued, until we see the market crash, nothing will be resolved.

Normally Treasury Bills are not something discussed around the dinner table or hotly debated on the business news channels. As UBS notes, the fact that the Tbill market has become the focus of attention is an ominous sign, and indicates that the stalemate over the debt ceiling could have profound effects. While TED-Spreads, and financial CDS were the key indicators in 2008, now we must watch money fund flows, and Tbill forwards. In a sense, the Tbill market is the proverbial canary in a coal mine for the US financial system. The canary is not yet back in good health.

Despite stock (not bond) euphoria yesterday that a DC debt ceiling deal was sealed leading to the second largest risk ramp of 2013, last night was spent diffusing the excitement as one after another politician talked back the success of a "non-deal" that Obama rejected, at least according to the NYT. As a result, with both retail sales data and the PPI not being released (and the only data of note the always leaked UMichigan consumer confidence) markets will again be at the behest of developments on Capitol Hill, with some talk from Republicans suggesting a deal as early as today could be possible in an effort to reopen government on Monday. It is entirely possible that talks could continue over the weekend though, which would ensure a gappy open to Asian markets on Monday.

As reported previously, the latest meme surrounding the D.C. impasse is that Obama is suddenly willing to compromise on a short-term, supposedly six-week funding and debt ceiling extension, on the verge of his latest talks with republicans at the White House scheduled for this morning, as previously floated by the GOP. Throw some additional headlines such as "Ryan steps up to shape a deal" (in line with what we predicted yesterday) and "The ice breaks; fiscal talks set", by The Hill, and "GOP quietly backing away from Obamacare" from Politico, and one can see why futures are in breakneck soaring mode this morning, driven as usual by the two main JPY cross (USD and AUD), the first of which is less than 100 pips now away from being Stolpered out.  So will a compromise deal finally emerge 7 days ahead of the first X-Date, or will a last minute snag once again derail the (non)-negotiations? We will know quite soon.

Not much comment necessary on a topic we have beaten to horse pulp in the past 2 weeks aside to note that this time is ironically different from 2011 as the inversion in the CDS curve is considerably more biased to a piling up of short-term default risk than in 2011.

The cost of protecting against a default on US Treasuries for one-year has surged to 60bps this morning. This is the highest since the Debt-ceiling debacle in 2011 and worse than Lehman. The 1Y cost is the highest relative to the 5Y cost ever. However, many people look at the 60bps and shrug it off as de minimus, after-all, JCPenney trades at 1200bps and is still alive. This is a mistake. The price of protection for US sovereign debt depends on recovery expectations and the EURUSD exchange rate expectations. Based on current levels, USA CDS imply a 5.9% probability of default - the same as JCPenney in July.

As we noted earlier there are some 'possible' scenarios that enable payments to be made on Treasuries prioritized over other payments but it would appear the short-term Treasury Bill market is becoming not just increasingly anxious about a technical default but is bringing that "X" date closer and closer. The 10/31/13 bill had been the "most risky" of the short-term bills until this weekend but the lack of a deal and no indication of a resolution any time soon has seen risk piling up in the 10/17/13 and 10/24/13 bills - the latter now at 16bps (that is 4 times the yield on the 11/21/13 bill). The 1-month-1-year spread is still inverted (even as USA CDS compresses on the day).

Having been dismissed on the first day of the shutdown, precious metals have surged back in the last few days and this morning, as no deal was achieved (surprising equity market 'investors' who seemed so sure Friday afternoon), are pressing up to post-shutdown highs. With the S&P near post-shutdown lows, and Treasuries only marginally bid, it seems precious metals are benefitting from the anxiety seen in USA CDS and short-term bills (+3bps more at 14bps today) at the resilience of the status quo.

David Stockman, author of The Great Deformation, summarizes the last quarter century thus: What has been growing is the wealth of the rich, the remit of the state, the girth of Wall Street, the debt burden of the people, the prosperity of the beltway and the sway of the three great branches of government - that is, the warfare state, the welfare state and the central bank...

What is flailing is the vast expanse of the Main Street economy where the great majority have experienced stagnant living standards, rising job insecurity, failure to accumulate material savings, rapidly approach old age and the certainty of a Hobbesian future where, inexorably, taxes will rise and social benefits will be cut...

He calls this condition "Sundown in America".

Yesterday we described the various scenarios available to Treasury in the next few weeks should the shutdown and debt ceiling debacle carry on longer than the equity markets believe possible. As BofAML notes, however, the most plausible option for the Treasury could be implementing a delayed payment regime. In such a scenario, the Treasury would wait until it has enough cash to pay off an entire day’s obligations and then make those payments on a day-to-day basis. Given the lack of a precedent, it is hard to quantify the impact on the financial markets in the event that the Treasury was to miss payment on a UST; but the following looks at the impact on a market by market basis.

Another day, another shut government and 1-month T-Bills have surged another 6bps to 18.5bps. Those who read our suggestion from Sept 26 to hedge the political stupidity and debt ceiling debate and put on the 1M1Y flattener have seen the fastest plunge and inversion (to negative!) in the curve since early 2009. Despite the relative calm in repo markets, which is likely due to expectations that any technical default will be for a minim al length, the short-term bills most likely to be affected (the 10/31/13 T-Bills) are seeing the largest daily deterioration yet as traders exit and price in the possibility of missed payment. 1Y USA CDS has spiked by a massive 26bps to 65bps, higher than during the Lehman crisis and second only to Summer 2011.

With short-term Treasury Bills starting to price in a missed payment possibility and USA CDS surging (though still low), the debt ceiling (and implicit chance of a technical default) is nigh. As we approach yet another debt ceiling showdown (especially in light of the seeming congruence of a CR and debt ceiling debate in an entirely divided Washington), market attention will turn towards a possible US sovereign rating downgrade. In this article, we provide an outline of the likely actions by the three rating agencies (S&P, Moody’s and Fitch).

It would appear that the almost $1bn capital raise secondary that JCPenney successfully completed last week - inspite of the lies - has done absolutely nothing to resolve market fears as JCP 5Y CDS surges 80bps to 1280bps (equivalent), a record high (and 1Y protection at 1210bps) and the stock price falls another 3.6% to $8.40 - the lowest since 1982. Just as Goldman had warned, liquidity remains a major concern and anyone who had bought the protection made up their losses on the stock they bought from Goldman on the secondary. The credit markets imply around a 25% chance of default within the year and 70% within 5 years.

It would appear that Warren Buffett's reassurance this morning that crossing the debt ceiling won't be so bad (trumpeted by any and all equity pitch men since) is being entirely ignored by the bond market. 1-month Treasury bill yields are soaring this morning - up 5bps at 12.5bps now (having touched 16bps - the highest yield in almost 3 years and notably higher than during the 2011 debt ceiling debacle). 1Y USA CDS are also up 3bps at 38.5bps this morning - notably inverted still. Of course, equity markets are surging back to open green for retail investors ignoring Obama's warning last night and Lew's "default has potential to be catastrophic" note this morning. In the meantime, the 1M1Y flattener trade we suggested goes from strength to strength as an indicator of market stress.

It just keeps getting worse and worse for Bill Ackman. A few weeks after the epic humiliation, not to mention even more epic losses, he suffered on his now defunct JCP long position (despite ample warnings by the likes of Zero Hedge who said long ago JCP is merely a melting icecube and fast-track Chapter 11/7 candidate) all those who predicted (such as Zero Hedge back in January) that an epic HLF short squeeze would result in the aftermath of Ackman's Herbalife short announcement leading to Ackman's ultimate capitulation, have been proven correct. Moments ago, in a letter to investors, Bill Ackman just announced that he has covered over 40% of his Herbalife short position, with his forced buy-in explaining the endless move higher in Herbalife stock in recent weeks. The explanation of being forced out of nearly half of his position is amusing: "we minimize the risk of so-called short squeezes or other technical attempts by market manipulators to force us to cover our position." So Ackman is forced out by his Prime Brokers so as not to be forced out by market manipulators? That's an interesting explanation for what is a far simple situation: booking your paper losses.