Thursday, November 19, 2009

Credit Markets, Liquidity, and Potential Asset Bubbles

Recently, one of the bearish analysts we read every morning alerted us to the fact that credit default swap premiums for government debt in the U.S., U.K., and Japan have been increasing in price lately. As a reminder, a credit default swap (CDS) is a derivative contract that is usually purchased by an owner of a debt security in order to hedge against a default by the debtor. For years we have lived within a system where government debt, particularly in the U.S., was assumed to have zero credit risk since it can not only borrow in the deepest, most liquid market in the world, but can also print money via the printing press should the need arise. However, as these CDS spreads rise, the market is beginning to price in less faith that the large developed countries, including the U.S., are 100% credit worthy.

Reasons for the recent rise in the cost of protecting against default seem quite reasonable, as the “Great Recession” has forced many developed countries to borrow vast sums of money to help patch together the financial system. And while things have worked so far, and the global economy seems to be slowly recovering, the markets are acknowledging that new imbalances are currently building and new risks are rising. Some analysts argue that there is room for debt to rise before public borrowing crowds out the private sector, while others are convinced the public debt binge has us on the precipice of a death spiral for the U.S. dollar.

I think it’s fair to say that the new imbalances and risks are the price we are paying for pulling out all the stops to contain the bleeding within the global financial system. But I also think it’s important to keep things in perspective. Excesses and bubbles can take years to build before they unwind. Even as the risks build, one must respect that the amount of liquidity in the system, combined with very low yield levels, may produce new asset bubbles that run further and longer than most currently anticipate. We will continue to monitor fundamentals and be mindful of current risks in the backdrop. But we will also be watching for areas that may be in the midst of developing into the next financial mania.