What Credit Default Swaps Say
For the moment, the stock market and the broader bond market are treating the debt ceiling negotiations as a nonevent. Other issues dominate: persistent inflation, high interest rates, bank failures, the possibility of an imminent recession and of a pivot by the Federal Reserve, after tightening financial conditions for more than a year.
The debt ceiling impasse in the summer of 2011 was different. Then, stocks fell sharply.
There has been no similar stock market action so far, and that may be partly because the credit default swaps market views the current situation as less risky than the 2011 crisis.
Credit default swaps are a form of insurance. When the prices, or “spreads,” of these securities rise, they reflect the market’s view that the underlying bonds, in this case, Treasuries, have become more risky. These spreads can be used to derive precise predictions about a default,
At the worst point back in 2011, swaps pricing implied a 6.9 percent probability of a U.S. debt default, according to Andy Sparks, managing director and head of portfolio management research at MSCI, the financial services company. This year, the most dire prediction from the swaps market came around May 11, when Mr. Trump made his comments. The default probability reached 4.2 percent then. With the news of progress in negotiations, it has hovered around 3.7 percent.
That’s a huge increase since January, when the default probability was near zero. But while the swap spreads are now much wider for Treasuries than they were in 2011, savvy market participants know that in calculating implied default probabilities, another important factor counts, too: the price of the underlying bonds.