09 December 2008

A Conundrum

One months ago, the yield on the 5-year Treasury note was 2.51%. Today the yield is 1.61%. Over the same period, the price of a Credit Default Swap for the 5-year Treasury, basically insurance against the Treasury not paying off, has risen to $60 per $10,000 insured from $35.70, an increase of 68%. (A year ago, the cost was $8.00 per $10,000.) In other words, the risk has gone up while the yield has gone down. Generally, so much money is flooding into Treasuries that short-term notes are trading at essentially 0, and some have a negative real yield (that is, the interest paid is less than inflation). Anyone want to offer an explanation?


pj said...

No conundrum. It's the difference between the mode of a distribution and the tail.

Let's say the default scenario is a total loss, for simplicity of analysis. Then the price of the credit default swap indicates that the probability of a return of zero has increased to 0.6%, from 0.35%. However, the modal return, dealing with the 99.4% of the time in which there is no default, is lower because market interest rates are lower.

So the market rate is = modal rate * .994 + 0 * .006, changed from modal rate * .9965 + 0 * .0035 a month ago, while the modal rate has fallen substantially.

Harry Eagar said...

Funny you should ask. I just got back from a discussion of that with Bank of Hawaii's chief economist.

He says the market is factoring in a certain (still smallish) risk of deflation; but the main sentiment is inflation.

Therefore, people with hot money are willing to accept 0 interest in order to protect principal.

6p00e3932f91d08834 said...

How exactly do you protect principal by trading cash for treasuries at 0%? Inflation would eat both at the same rate.

6p00e3932f91d08834 said...

Gah, SixApart does it again. They moved my OpenID from Typekey to Typepad and now it doesn't work. Sigh. You can tell it's me, though, if you click on the name link.

Harry Eagar said...

You can't, but these guys have short time horizons, I guess.

Whatever, I bet we'll hear a lot less about signing oil contracts in rubles from now on.