Don’t believe the U.S. default-fear hype

May 27, 2011, 2:36 PM UTC

Yes, bond-market bets against the United States are rolling in.  But they aren’t the tidal wave you might have heard about.

The brink-of-fiscal-disaster crowd took heart this week when a chart made the rounds showing a near-tripling in the prices of shorter-term U.S. credit default swaps. The spike was cited as evidence that the bond market is about to turn on us — despite a strong rally in Treasury bonds.

Not so nervous

But don’t get carried away with this version of the U.S.-in-quicksand story. Though bets against the United States have jumped, particularly in the thinly traded year-or-less category, prices for the more heavily traded five-year CDS remain stable (see less exciting chart, right).

What’s more, U.S. debt remains an also-ran in the highly competitive global oblivion sweepstakes, where Europe has a running start.

Though the U.S. Treasury market is by far the largest bond market in the world, the open interest in credit default swaps referencing Treasuries ranks just 29th. There are six times as many bets against Italy and five times as many against France as against the United States, going by the net value of the wagers being made against each country’s bonds.

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Topping this list are the big bond issuers in Europe, along with Brazil (see list, bottom right). Also ranking ahead of the United States are numerous banks (Bank of America (BAC), Goldman Sachs (GS), Deutsche Bank (DB)), insurers (Berkshire Hathaway (BRKA), Metlife (MET)) and assorted financial companies (General Electric’s (GE) GE Capital).

Why all the interest in those outfits? Well, there is the small problem of the oncoming euro crisis to consider. It is likely to hit even the stronger European countries’ finances in an echo of 2008. And of course any financial meltdown is apt to be bad for the banks, as central bankers are all too aware.

We're No. 29!

“I’m only speculating here, but there are a lot of reasons for people to be hedging against all these different things,” says Lisa Pollack, who watches credit markets at data provider Markit in London. “From a risk management perspective, you can really see someone at a bank saying, Do I want to hedge here? And the answer is yes.”

Before the financial crisis started taking shape almost four years ago, the answer was often no, as implausible as that seems now. In 2007 the annual premium on five-year U.S. CDS was a negligible $2,000.

That couldn’t last and didn’t.  Betting Treasury will default on $10 million of five-year bonds currently costs about $50,000 annually — up from $8,000 in the spring of 2008, before the decision to bail out the banks took a chunk out of U.S. creditworthiness.

Over the same period, the amount of money that would change hands in the event of a U.S. default – the so-called net notional amount of credit default swaps outstanding on Treasury securities – rose to $4 billion from around $500 million in May 2008, according to Markit. That figure has doubled over just the past year, according to Depository Trust & Clearing Corp. data.

None of these trends are particularly reassuring, obviously. Even so, the U.S. isn’t the only country to make the market nervous — or, at the very least, to attract bets from those who think the going is going to get tougher. Since the end of 2008, the U.K. has become the sixth-most bet-upon entity, up from 92nd; Belgium has moved up to 10th from 31st; and France has moved up to No. 2 from No. 12.

“So the U.S. moving from 322nd to 29th is maybe a little less odd than it looks at first blush,” says Pollack.

That isn’t to say the United States is incapable of doing something stupid and blowing itself up in a congressional game of chicken over the debt ceiling, for instance. Nor is it to assume that our political leaders will heed common sense and actually come up with a plan to pare our debt back to reasonable levels over time. It is totally legitimate to be nervous about our so-called leaders’ failure to take these problems seriously.

But that’s all the more reason, really, to stop sweating what’s going on in the bond market. The real drama is playing out in Washington — and no one, investor or otherwise, can say exactly how that might end.