What is the Swap Market Telling us about a U.S. Credit Rating Downgrade?

In my blog of April 2010, I pointed out that the last time swap spreads were trading negative to government bond yields, the credit rating of Japanese sovereign debt fell below AAA  (http://blog.reval.com/posts/should-the-us-government-debt-rating-be-downgraded-swap-spread-market-is-saying-yes/). 

Typically,  swap spreads trade positive to a benchmark government yield curve as the money center banks that are part of the LIBOR index are rated between single A and double AA whereas the governments are usually AAA and would therefore have a lower yield, reflecting lower risk.

At the peak of the financial crisis 10 year US swap spreads were trading at negative nine basis points where typically they would average closer to +45 basis points over US Treasuries.  For most of 2011 the 10 year swap spreads have remained positive in the high single digits and are hovering around + 9.0 basis points.  Still a paltry spread but at least not negative.  So what is the market telling us?

Well for one, the market (and my blog!) was a very early predictor of a U.S. credit rating downgrade if this event does indeed occur as a result of the game of chicken the government is playing with the debt ceiling.  But why isn’t the swap spread trading at a negative spread today given the current state of U.S. affairs?  There was a lot more uncertainty in 2010 and words like the Great Recession or Depression were being used versus today, where perhaps we are in or heading towards a double dip recession.

Another factor is that there is probably still a majority held view that the U.S. government will not default and at some point soon, either the Democrats or Republicans will swerve and end the game. However, even if the debt ceiling is raised, there is a good chance that there still could be a downgrade, and we may see swap spreads go lower.  Worse yet, if there really is a default and a downgrade, maybe we will see negative swap spreads again.   Either way, a less than triple A rated U.S. government bond rating will make any American feel negative!