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Only 7 basis points away

Below are the 5 year credit default swap rates for selected countries. We note the US enjoys a mere .07% pa advantage over Germany and has only .59% basis points separating us from France.

5 yr CDS / .00% pa

Counter party






United Kingdom  


















Well, a little math: if the yield on the 5 year US Treasury is 1.75% pa, and we strip out the credit risk (a novel concept for those who used to think the US Treasury represented the ‘risk free’ rate) you get something like 1.36% which on a good day should include the embedded real interest rate, inflation expectations, and counterparty risk on the swap. Think about that for a minute while we wander elsewhere.

We have John Taylor  in today’s WSJ (perhaps taking the cue from WWB?) blasting Congress for fundamental potentially fatal flaws in the putative “financial reform” legislation. We have President Obama now threatening critics with “calling their bluff” next year by “presenting some very difficult choices.”

Meanwhile we have in Daniel Henninger commenting on the decay in the rule of law, quoting Justice George Sutherland: “a statue which either forbids or requires the doing of an act in terms so vague that men of common intelligence must necessarily guess at its meaning… violates the first essential of due process of law.”

Unfortunately Judge Sutherland has come to describe much of the legal and regulatory status of modern economic and private life today. By operation of complexity or lack of clarity good faith compliance with law or regulation has become nearly impossible, a stochastic venture in the Heisenberg principle[1]. This has the consequence that enforcement has become chaotic at best or discretionary at worst. Mel Brooks is correct: “it’s good to be the king.”

Outcomes matter. Is Mel Brooks or George Washington working the levers? Allocators of capital don’t have the luxury of waiting for visions of clarity. The cash is here, what’s the trade? Take zero to negative real returns on short term, low risk assets or ponder the range of risks and uncertain returns imposed by chaotic political, fiscal, monetary, regulatory, and legal frameworks? For the bricks & mortar crowd, build the factory here or abroad, or scrap it altogether?  

Uncertainty paralyzes capital which impairs productivity. Consider the response of a risk officer when asked if the risk of the deal was acceptable:

           “Risk in & of itself is rarely unacceptable. The question is at what price?”  

Well, the Dow seems to be pushing 9,500 and the US is only 7 basis points away from parity with Germany. We, meaning the United States and its citizens, now have fewer valuable goods & services, less wealth, and our risk profile has increased. You can price it by the minute.

And let’s go back to that mysterious 1.36% we came to at the beginning of this posting ... seems like the market isn’t scared of inflation. Deflation seems to be the major concern. Keynesian economics basically claims that value is created by borrowing from Poppa to pay Peter to dig a ditch and then to pay Paul to fill it back up (you do recall Cash for Clunkers?). We are now borrowing from the unborn children of Peter and Paul to pay for the digging and filling up of holes.

The market is pricing in quality & effectiveness of governance and uncertainty of rule of law, also known as country risk, for the US. It also seems that deflationary expectations now dominate those of inflation, a sobering thought. Equities are getting significantly cheaper and that, for proper context, in face of greater risks. Treasuries are either cheap or dangerously expensive, depending on your view of the inflation vs. deflation argument. 

Our bias shows, so we may as well say it directly. You better have some cash on hand. Rebalance to get some equities cheap (buy on ugly and be prepared for uglier). Stay short & high quality on the fixed income side. We discourage trying to juice yield via duration, credit risk, or artifice. There is no free lunch, and the market will mete out a rough frontier justice to those who think so.

Farmers know the fallacy of Keynes, that crops must be grown before they can be eaten. Or taxed.


[1] We cite Tim Geithner’s plea as to Turbo Tax but leave the reader to determine the issue of good faith.

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