Almost no one outside of a few trading desks had even heard of credit default swaps before the 2007-2008 financial crisis. Then the hedge-funder John Paulson used them to make a lot of money while AIG used them to lose a lot of money and now everyone feels compelled to refer to them, even when discussing political issues such as the U.S. debt ceiling. The movement in CDS rates on Treasuries, the Economist warns, is now more typical of what is "seen in distressed markets where investors are pricing in an imminent default than with otherwise healthy borrowers with long-term problems."
This is all overblown. The size of the CDS market for U.S. government debt is so small and the trading volume is so thin that there really isn't much one can learn from small short-term movements.
According to the Bank for International Settlements, which measures these sorts of things, the gross notional value of all the credit default swaps in the world at the end of 2012 was about $25 trillion. However, the notional value of contracts protecting against a default by the U.S. government is just a few billion dollars -- or about 0.02 percent of the world's total. That's tiny.
The last time people worried about default thanks to debt ceiling shenanigans, back in the summer of 2011, traders bought and sold only 41 contracts per week, with a daily notional volume of just $250 million. Given the low cost of these contracts, the market value of those trades would have been orders of magnitude smaller. Even a retail investor could have participated, had he been dumb enough to do so. A few fat or misinformed fingers could easily have pushed the price around.
This probably explains why the cost of buying protection against a default by the U.S. government has increased since last month. It would only take a few people who think they understand politics and definitely don't understand markets to move prices around. That said, it is interesting that the cost of buying protection for one year has risen so much more than the cost of buying protection for five years that the credit curve has become inverted:
Similarly, Cardiff Garcia the Financial Times notes that treasury bills maturing at the end of October have become cheaper than bills maturing in mid-November -- a reversal from last week. In other words, the market pricing implies a slightly higher risk of default in the immediate future than it does over slightly longer periods. These developments make sense if you think that congressional unwillingness to raise the debt ceiling by the end of October might force a default in the absence of any inability to pay. Some people even recommended making that trade on Monday morning, with appropriate caveats.
Of course, even if the U.S. government temporarily missed some payments, you still might be a chump for having purchased CDS. That's because the contracts are supposed to offset investor losses. Once the government eventually raised the debt ceiling and paid back creditors with interest, as it almost certainly would, the CDS contracts would pay out precisely $0. This is partly reflected by the low cost of protection on U.S. sovereign debt, but it is mostly reflected by the tiny size of the market and the fact that it is avoided by most sophisticated investors.
Bottom line: Don't look to credit default swaps to understand what's happening -- or not happening -- in Washington.
(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)