Editor’s note: This article is the second in a three-part series. Plain text represents the writing of Greg Foss, while italicized copy represents the writing of Jason Sansone.
In part one of this series, I reviewed my history in the credit markets and covered the basics of bonds and bond math in order to provide context for our thesis. The intent was to lay the groundwork for our “Fulcrum Index,” an index which calculates the cumulative value of credit default swap (CDS) insurance contracts on a basket of G20 sovereign nations multiplied by their respective funded and unfunded obligations. This dynamic calculation could form the basis of a current valuation for bitcoin (the “anti-fiat”).
from a level in the early 1980s of 16% in the U.S., to today’s rates which approach zero (or even negative in some countries).
A negative yielding bond is no longer an investment. In fact, if you buy a bond with a negative yield, and hold it until maturity, it will have cost you money to store your “value.” At last count, there was close to $19 trillion of negative yielding debt globally. Most was “manipulated” government debt, due to quantitative easing (QE) by central banks, but there is negative-yielding corporate debt, too. Imagine having the luxury of being a corporation and issuing bonds where you borrowed money and someone paid you for the privilege of lending it to you.
Going forward, interest rate risk due to inflation will be one directional: higher. And due to bond math, as you now know, when interest rates rise, bond prices fall. But there is a bigger risk than this interest rate/market risk that is brewing for government bonds: credit risk. Heretofore, credit risk for governments of developed G20 nations has been minimal. However, that is starting to change…
famously referred to CDS as a “financial weapon of mass destruction.” That is a little harsh, but it is not altogether untrue. The sellers of CDS can use hedging techniques where they buy equity put options on the same name to manage their exposure. This is another reason that if CDS and credit spreads widen, the equity markets can get punched around like a toy clown.
Many readers may have heard of the CDS. Although technically not an insurance contract, it essentially functions the exact same way: “insuring” creditors against a credit event. Prices of CDS contracts are quoted in basis points. For example, the CDS on ABC, Inc. is 13 bps (meaning, the annual premium to insure $10 million of ABC, Inc. debt would be 0.13%, or $13,000). One can think of the premium paid on a CDS contract as a measure of the credit risk of the entity the CDS is insuring.
The one-month and s-month variance on five-year CDS pricing of Turkey’s sovereign debt is +22.09% and +37.89%, respectively. Note: The yield on the Turkish 10-year government bond currently sits at 21.62% (up from 18.7% six months ago).
CDS premium on U.S. sovereign debt costs 16 bps. To my knowledge, 16 bps is greater than zero. You can look up CDS premia (and thus the implied default risk) for many sovereigns at WorldGovernmentBonds.com. Remember, price is truth…
Bond Risk Three: Liquidity Risk
What exactly is liquidity, anyway? It’s a term that gets thrown around all the time: “a highly liquid market,” or “a liquidity crunch,” as though we are all just supposed to know what it means… yet most of us have no idea.
The academic definition of liquidity is as follows: The ability to buy and sell assets quickly and in volume without moving the price.
OK, fine. But how is liquidity achieved? Enter stage left: Dealers…
“They know nothing!”), when on a sunny afternoon, in early August 2007, he lost his patience and called out the Fed and Ben Bernanke for being clueless to the stresses.
Well, the Fed did cut rates and equities rallied to all-time highs in October 2007, as credit investors who were purchasing various forms of protection reversed course, thus pushing up stocks. But remember, credit is a dog, and equity markets are its tail. Equities can get whipped around with reckless abandon because the credit markets are so much larger and credit has priority of claim over equity.
It is worth noting that contagion in the bond market is much more pronounced than in the equity markets. For example, if provincial spreads are widening on Ontario bonds, most other Canadian provinces are widening in lockstep, and there is a trickle-down effect through interbank spreads (LIBOR/BAs), IG corporate spreads and even to HY spreads. This is true in the U.S. markets too, with the impact of IG indices bleeding into the HY indices.
“Bear Traps Report” on January 27, 2021:
five-year CDS rates on the following countries:
- USA (AA+) = 16 bps
- Canada (AAA) = 33 bps
- China (A+) = 64 bps
- Portugal (BBB) = 43 bps
global debt/global GDP was 3.3x. Global GDP has grown a little in the last three years, but global debt has grown much faster. I now estimate that the global debt/GDP ratio is over 4x. At this ratio, a dangerous mathematical certainty emerges. If we assume the average coupon on the debt is 3% (this is conservatively low), then the global economy needs to grow at a rate of 12% just to keep the tax base in line with the organically-growing debt balance (sovereign interest expense). Note: This does not include the increased deficits that are contemplated for battling the recessionary impacts of the COVID crisis.
In a debt/GDP spiral, the fiat currency becomes the error term, meaning that printing more fiat is the only solution that balances the growth in the numerator relative to the denominator. When more fiat is printed, the value of the outstanding fiat is debased. It is circular and error terms imply an impurity in the formula.
Therefore, when you lend a government money at time zero, you are highly likely to get your money back at time x; however, the value of that money will have been debased. That is a mathematical certainty. Assuming there is no contagion that leads to a default, the debt contract has been satisfied. But who is the fool? Moreover, with interest rates at historic lows, the contractual returns on the obligations will certainly not keep pace with the Consumer Price Index (CPI), let alone true inflation as measured by other less-manipulated baskets. And notice we have not even mentioned the return that would be required for a fair reward due to the credit risk.
I paraphrase the main question as follows: If countries can just print, they can never default, so why would CDS spreads widen? Make no mistake: sovereign credits do default even though they can print money.
Remember the Weimar hyperinflation following World War I, the Latin American Debt Crisis in 1988, Venezuela in 2020 and Turkey in 2021, where fiat is (actually or effectively) shoveled to the curb as garbage. There are plenty of other examples, just not in the “first world.” Regardless, it becomes a crisis of confidence and existing holders of government debt do not roll their obligations. Instead, they demand cash. Governments can “print” the cash, but if it is shoveled to the curb, we would all agree that it is a de facto default. Relying on economics professors/modern monetary theorists to opine that “deficits are a myth” is dangerous. The truth may be inconvenient, but that makes it no less true.
We conclude this section with a visual flowchart of how things could theoretically “fall apart.” Remember, systems work until they don’t. Slowly then suddenly…
Proceed accordingly. Risk happens fast.
This is a guest post by Greg Foss and Jason Sansone. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.