Last Updated: 13 September 2023
Courtesy of CMA DataVision, the credit market information specialists, here is a chart of the 10-year credit default swap spread for US Treasury bonds, from the beginning of the year.
The cost of insuring against a debt default by the US government, which was trading at 1.6 basis points in the middle of last year, has just hit 40 basis points – a 25-fold increase over the period. The UK government is even more of a risk, at 66 b.p., and Germany registers a little behind, at 37. What’s going on?
The state interventions of the last year, intended to shore up the global economy, have already had some unexpected consequences: the emergency rate cuts of last autumn led directly to a dollar slump, soaring commodity prices and food riots; granting commercial bank status to Goldman Sachs and Morgan Stanley, both leading prime brokers for hedge funds, may have accelerated the deleveraging process and exacerbated the equity market falls; allowing banks to mainline credit from the Fed may have caused interbank lending to dry up…could government borrowing to bail out the financial sector have the biggest unexpected consequence of all – national default? If you had written this up as a movie script two years ago I doubt you’d have got it past the agent’s desk. But nothing seems impossible these days, and these CDS spreads bear very careful watching.
As I wrote last week, US ETF investors are better served in being able to express negative views on government bonds than we are in Europe. The ProShares ultrashort 20+ year Treasury ETF (AMEX: TBT) has crept slowly up in assets in the last month, from USD 300 million to nearly half a billion, even as Treasury yields hit new lows.
In Europe, the only inverse bond-related ETFs are db x-trackers’ credit market funds. So to express a bearish government bond view investors would have to physically short one of the long government bond ETFs, and even these tend to aggregate different sovereign issuers from across the Eurozone. This makes taking a long or short position via an ETF on an individual government’s bonds – the UK, Germany, Greece, Spain, for example – practically impossible. And why should emerging market countries such as Russia and Ukraine, where there’s been plenty of recent activity in CDS spreads, be excluded, come to think of it?
At this point I should disclose an interest – I own a short US treasury position, since last week. Anyway, maybe these concerns are overstated, and long bond yields will follow short rates on a downward trajectory, just as they did in Japan in the 1990s (eventually bottoming at a yield of 0.5% for ten year bonds). Let’s hope my stop works…
Meanwhile, there have been fun and games in the German market, where Porsche has performed a remarkable short squeeze on Volkswagen shares. Its acquisition of a 70%-plus stake, while lending out shares to hedge funds to short and then effectively forcing them to cover at much higher prices, has apparently earned a multi-billion Euro profit and incidentally propelled VW (no doubt only briefly) to the status of biggest company in the world by market capitalisation. It may have bankrupted some hedge funds, and it has certainly led to some anguished complaints about market manipulation (presumably by the shorts).
Apart from reminding us how risky short-selling can be, this has left me pondering the implications for ETFs. I suppose it reminds us of the benefits of diversification, but surely this is another nail in the coffin of the efficient market theory. And it also shows some of the weaknesses of cap-weighting. I suppose investors would be less than amused if this incredible spike in VW shares had happened on the day of an index rebalancing, causing an ETF – let’s say, hypothetically, one of the DJ Stoxx 600 Automobiles and Parts ETFs – to take a massive weighting in a stock that subsequently collapsed. The most recent, end-September DJ Stoxx factsheet for that index – which is cap-weighted – showed Volkswagen with a 33% index weighting. This would surely have doubled – at least – if the index had been recalculated based on yesterday’s closing prices.
An extreme case, no doubt, but food for thought.