U.S. Default? The Bond Markets Have Known All Along

In the past couple of weeks, one of the leading stories in any sort of media has been the prospect of default by the U.S. on its government bonds, due to running out of Congressionally-approved debt capacity. I have never thought it very likely, but we are getting close to the deadline and the prospect of a default has become a little nerve-wracking. A look at several bond market indicators, however, shows that the people who do this for a living in the world markets are no more concerned about default -- at least not by the U.S. -- than they were in January, before all this debt ceiling stuff came up.

I've written about this before, including one note a couple of months ago that suggested that maybe the markets were a bit worried. But we're very close to the deadline, and the markets really haven't taken a potential default to heart. Let's take a look at a few indicators.

First is the bond market itself. If the U.S. went into default, even a technical default of some sort, it would mean that bondholders weren't as assured of getting their interest and principal payments, and the way the markets compensate for that is by demanding higher yields. Interest rates would go up a lot.

But of course the markets don't wait for such things to happen -- as soon as there were any suspicion of things going wrong, bond prices would fall and yields rise. That's what's going on in Italy at the moment, for instance. Here is Bloomberg's account of trading this morning:

"Both Italy and Spain are starting to look more vulnerable," said Niels From, chief analyst at Nordea Bank AB in Copenhagen. "The fear is that this is going to continue as the market starts focusing on the larger euro-region nations."

The yield on Italy's two-year bond climbed 45 basis points to 3.96 percent, and Spanish yields increased 37 basis points to 4.14 percent. Greek yields jumped 83 basis points to 31.21 percent, and its default swaps climbed 124 basis points.

Looking again at the U.S. yields, two-years have drifted up and down, but the direction lately has been down, suggesting that among the world's bond markets, the U.S. is the least risky. Or close to it -- the German 10-year bond trades at a lower yield than the U.S. by about 0.3%.

The second indicator is credit default swaps, which essentially are insurance policies on bonds. It's a derivative contract, where the holder of bankrupt bonds is paid 100 cents on the dollar in the event of default.

Here are the costs to insure against default on a five-year government bond for a group of big ostensibly stable countries over the last few months:

The cost of insuring against a U.S. default is still low, and more to the point, is not up much from six months ago, before the debt ceiling issue started to bear down on us.

The last and least weighty indicator is the prediction market Intrade, which is an online market for betting on all sorts of political, economic and sports events. Intrade says that its bettors believe there's an 80 percent chance of the debt ceiling being raised to $15.1 trillion or more by the end of August -- that is, 80 percent chance of no default. (They also say the chance of a default by Greece is 50 percent.)

To sum up -- the bond markets know these things best, and it looks as though they are not concerned about U.S. default. In within a day or two we will almost certainly have some sort of deal from Congress, that includes higher taxes, lower spending, and a raise to the debt ceiling. We can all stop holding our breath.