default

Marc Faber on U.S. downgrade, market direction, plus some thoughts from us.

In a much anticipated statement, Obama just announced that he has struck a deal with Boehner on the debt and the deficit, which will allow the US to avoid default. And also, as Reuters adds, Obama said that spending cuts included in deal to raise the debt ceiling will not happen so quickly that they will drag on the fragile U.S. economy. In other words, there will be no cuts for the immediate future. But there will be a single $2.4 trillion debt ceiling raise (based on a Joint Committee green light, LOL) just as Obama desired. And of course, there will be no tax hikes. Bottom line: there will be about $40 billion in actual, real spending cuts until the next, $16.7 trillion debt ceiling limit is hit some time in Q1 2013, at which point it will have to be raised to $20+ trillion. But no really, they are cutting spending and all that.

Whether 'tis nobler at this time to suffer
The slings and arrows of outrageous financial misfortune,
Or to take arms against a sea of rising debts

Yesterday we reported of a dramatic dispersion between the just maturing July 28 Bills and the "post default" August 4th version of short-term funding. We also suggested that this is probably a spread that should be promptly collapsed as in the very unlikely event there is a default, the last thing on your counterparty's mind will be trying to collect the several MMs owed to him. Well, the July 28s matured today, and the spread appears to have evaporated. Not so fast. Those who so wish, can still put on the compression trade, although not using plain vanilla bonds, but CMBs instead. In fact, as of today, traders can capitalize on the Treasury's D-Day, with the spread between the August 2 and August 4 CMBs rising from 5 bps to 11 bps in 2 days. Now the reason why this trade, with lots of leverage would be ideal, is that, as mentioned above, if the US does default, Repo desks and Prime Brokers will have much muich bigger problems, and two, as we pointed out, it will imminently become "uncovered" that the Fed has a secret stash of cash, up to the amount of about half a trillion, which may easily carry the Treasury through the new year, in which case the spread will immediately collapse. Of course, we could be wrong, and everyone who plays the compression will blow up in an epic supernova that will make Boaz Weinsten's legendary basis trade annihilation seems like amateur hour.

The US has entered a debt spiral: a situation in which more and more debt needs to be issued at the same time that lenders are unwilling to lend to the US for any lengthy period of time (greater than three years). On top of this, the US must to roll over trillions in old debt at the same time that it needs to issue an additional $150 billion in debt per month to finance its current deficit.

Things are getting real. After all the bluffing, huffing and puffing by Geithner, the rating agencies, and anything with a pulse and a TV or radio pulpit has failed, the last trump card is coming down. While yesterday the Treasury informed that it would not disclose any details of its contingency plan, Bloomberg has just learned via a Treasury leak that the US government will give priority to bondholders. From Bloomberg: "The U.S. Treasury will give priority to making interest payments to holders of government bonds when due if lawmakers fail to reach an agreement to raise the debt ceiling, according to an administration official. The official requested anonymity because no announcement has been made. The Treasury has said about $90b in debt matures on Aug. 4 and more than $30b in interest comes due Aug. 15. Overall, more than $500b matures in August." And so it begins: while the Treasury has not yet pushed the big red flashing button, this leak is nothing but it latest and greatest bluff. It also means that America will, indeed default, next week, as the absence of a contractual payment is a default. And then we get into the fine print with the rating agencies whether or not X is default but Y is not. At that point however it won't matter: every form of intermarket liquidity will be permanently gone as Lehman will be a cherished walk in the park. Thank you Tim Geithner and your total lack of contingency plans.

In the past week, almost every single sellside bank and their mother has released a report on "what happens to the US if there is a [default|debt extension|compromise|zombie apocalypse (if one believes Tim Geithner)]. Sure enough, here is Credit Suisse with its three scenarios. This is notable as it presents the binary outcomes for the stock markets as a result of what develops in Congress. The scenarios are: i) debt ceiling extension (market up 3%); ii) debt ceiling not extended (market down 15%); iii) default (market plummets by at least 30%). Of course, if there is really is a default it is game over for equity markets but that is a moot point. Either way, any report that has zero mention of the word gold when contemplating the impact of a US default goes straight into the garbage. Such as this one.

ISDA is getting nervous, or rather the same contingent of clueless "asset managers" who listen to ISDA as religiously as they listen to the rating agencies, is getting nervous. The boilerplate: "The following are responses to the most frequently-asked questions that ISDA has received in connection with a potential CDS Credit Event on US sovereign debt. The following does not constitute legal advice, and is subject in all respects to any determination that the ISDA Americas Credit Derivatives Determinations Committee may make in relation to CDS referencing the United States.  ISDA makes no comment on the likelihood of the events described in this Q&A." True - for the likelihood of any event happening, your best bet is to ask Turbo Tax Tim, and then multiply the answer by -1.

Gold is marginally higher against most currencies today and is trading at USD 1,614.40, EUR 1,130.50, GBP 990.08 and CHF 1,294.50 per ounce. Gold is flat against the dollar but remains just less than 1% from the record nominal high reached yesterday ($1,628.05/oz).  The euro is under pressure again today and gold is 0.7% higher against the euro and is just less than 1.5% away from the record euro high of EUR 1,144.80/oz reached last Monday. Investors were made nervous by comments from chemicals major BASF, which said it saw global economic growth slowing as it posted weaker-than-expected earnings, sending its stock down 4.9%. Siemens AG, Europe's largest engineering conglomerate, warned that global economic risks were increasing and posted below forecast results. Its shares fell 1.3%. The Dow to Gold Ratio has again turned down suggesting gold may continue to outperform U.S. stocks and the DJIA, in particular, in the coming weeks. The long term target of below 2:1 remains viable.

As Bloomberg reports, the spread between the July 28 and the August 4 T-Bills, two instruments that mature within a week of each other, and which differ by absolutely nothing else, has just surged to the widest ever, as investors are happy to roll away from long maturity instruments (even if longer maturity in this case means one week down the road) and dump securities that mature after the debt ceiling deadline for fear they will not get repaid. As for what is happening with the August 25 Bill, see second chart below. Yes: the market is starting to price in the unmentionable.

When we looked at the notional change in net outstanding CDS on the top 25 reference entities tracked by DTCC last week, we first made the discovery that the US has for the first time surpassed Greece in number of net speculative default bets outstanding. It was, also, the most rerisked name in total monthly notional, outpacing China and Japan in second and third place. Following tonight's weekly update from DTCC we get an even starker picture of where America lies on the risk spectrum: just to the left of UniCredit and Italy (left being bad). As the chart below indicates, the monthly percentage change in the number of net CDS contracts outstanding on the US increased by a whopping 10%, beating such insolvent entities as Italy's top bank and Italy itself (with mega black swan China, and 200% debt/GDP Japan coming in 4th and 5th place). And completing the bad news for the US from the perspective of a CDS trader, is that for the first time ever, US 1/5 year CDS inverted. Why? Because with American recovery rates well in the 80s based on trading prices of the cheapest to deliver bonds, unlike other sovereigns such as Greece which may need recovery calcs in the 20s or 30s, this is virtually equivalent to trading points up front and convexity is massive. It also means that with the 52 week Bill pricing at 0.2% earlier today, anyone who wishes to transact in a 1 year basis trade, can make a lot of money by putting on the negative basis courtesy of the blow out in 1 Year CDS compared to cash... assuming the US does not default of course. But in that case one will be bigger problems than paying their counterparty the require variation margin.

Round Two of the Crisis, the Sovereign Debt Round, began over Thanksgiving of 2009 when Dubai had a “virtual default,” asking for a six-month extension on $60 billion worth of its debt. The issue then spread to Greece over Christmas 2009. It will not end there. It's coming to the US's shores soon.

ISDA is rapidly deteriorating to rating agency status when it comes to credibility. After it made it all too clear in the past few weeks that no matter what happens it would never "determine" Greece (or any other European insolvent country) to have breached a CDS trigger (as that would apparently destroy the world), the same trade association (logically enough comprised of the same firms that make up the heart of the status quo) has joined the rating agencies, and as of last night the CME, in making it all too clear that a debt ceiling plan (preferably Reid's because it achieves absolutely nothing) has to pass, or else, after it earlier announced that the US has precisely 3 days to cure any missed debt payment before US CDS are triggered. Obviously this can not be allowed to happen, so expect this latest development to be used by the president in his nighlty scaremongering session.

You know, it's downright frightening how clearly this was able to be anticipated well over a year ago, yet it appears as if the EU politicking behind the bailout bonanza STILL leads down the road to perdition.

Default will be painful, but it is all but inevitable for a country as heavily indebted as the U.S. Just as pumping money into the system to combat a recession only ensures an unsustainable economic boom and a future recession worse than the first, so too does continuously raising the debt ceiling only forestall the day of reckoning and ensure that, when it comes, it will be cataclysmic. We have a choice: default now and take our medicine, or put it off as long as possible, when the effects will be much worse.