This CDS report was written by Markit’s Gavan Nolan
John Kenneth Galbraith, the Canadian economist, is remembered for many things. His masterly account of the Great Crash of 1929 is being re-read by policy makers and laymen alike, while the Keynesian ideas laid out in The Affluent Society (1958), long ridiculed by the monetarist consensus, are now back in vogue. But arguably the most familiar contribution he made to the popular discourse was the coining of the phrase “conventional wisdom”. And there is no doubt what the conventional wisdom is now in the financial markets.
Investors are convinced that the US economy that is set to return to growth in the second-half of the year. Markets have sustained a long and considerable rally, with the Markit CDX IG index set to close below 140bp today for the first time since last September. Economists support this view. A panel of 45 economists this week said that they expect the US economy to emerge from recession before the end of the year, with most expecting a resumption of growth in the third-quarter.
A silver lining can even be found in US Q1 GDP figures. The initial reading of a 6.1% contraction was only marginally worse than the negative 6.3% in Q4 2008, the worst figures since 1982. But the Q1 figure was revised today to a contraction of 5.7%, with slower liquidation of inventories accounting for most of the uplift. A better than expected consumer confidence figure, also released today, provided more food for optimists.
One would assume that the consensus view of a surprisingly swift end to the recession would be positive for US government finances. Indeed, the chart above shows that US sovereign CDS spreads have recovered from the 100bp levels reached in February. A depression is no longer on the agenda. But the past few weeks have seen sovereign spreads widen in the major economies, breaking the strong correlation with the corporate market. US sovereign spreads reached 50bp today for the first time in nearly two months.
The reason? Now that a 1930s scenario seems to have been averted, investors are now focusing on the cost of getting the US – and the world – out of recession. The stimuli planned by the US, UK and other industrialised countries are putting an enormous strain on their fiscal positions. Last week, S&P raised the prospect of the UK losing its prime AAA rating. The agency highlighted the risk of the country’s debt to GDP ratio rising beyond 100% – a level reminiscent of the more profligate members of the EU.
Attention then turned to the larger “Anglo-Saxon” economy: the US. Its debt levels are rising rapidly as automatic stabilisers and additional fiscal stimulus increases the public sector borrowing requirement. The means of funding this deficit, US Treasury auctions, was the catalyst for the widening in sovereign CDS spreads this week. Three separate auctions tested the willingness of investors – most of them foreign – to fill the funding gap. The 10-year Treasury dropped sharply in value following the massive increase in supply (see chart above), though it has recovered slightly after the last of the auctions – a 7-year issue – received ample demand.
The conventional wisdom may well be proved right in forecasting a return to growth this year. But the growth could turn out to be anaemic. Obama and Brown deserve some credit for facing down their conservative critics and implementing an aggressive response to the recession. However, investors are looking for a credible strategy in returning government budgets to some semblance of normality. Sovereign CDS spreads will be an important barometer of their skepticism.