Today's Major Market Move: UK 5 Year CDS Decline 36% Year To Date

Along with rising equity prices, this has also been a year of declining sovereign CDS prices. Interest rates on sovereign bonds have come up recently in some places like the U.S., the U.K and Japan but almost all CDS prices (PIIGS company not included) have been and continue to decline since the beginning of the year.  Of the 30 different credit default swaps we track, only 3 have gone up in price in 2012 all three of those are tied to the PIIGS. Here's the bottom 10 performers (in terms of higher prices, i.e. higher default risk):

Click here to go to the live table.

On the other end of the sovereign CDS spectrum, where prices have declined significantly, we have the topic for today's post: the UK 5 Year swap. It's been the 5th best performer this year having declined 36.4% and is down 41% from its 2011 high.

Click here to go to the live chart.

There was a very interesting comment last month by Mervyn King, head of the BOE. He said (hat tip to the Economist):

I have absolutely no doubt that when the time comes for us to reduce the size of the balance sheet that we'll find that a whole lot easier than we did when expanding it.

That is very vague and leaves a lot to the imagination as to what the actual methods are that the BOE is considering for reducing the size of the balance sheet. The BOE expanded the balance sheet by buying £325 billion worth of Gilts. So one obvious reduction method would be to sell those same bonds back out on to the open market. However we wouldn't consider this option 'easy' since doing so is going to drive up rates, perhaps significantly. We suspect the UK economy is a long ways away from being able to handle any kind of pronounced rise in rates.

Another option would be to simply "write the debt off". The banks get to keep the money that the BOE paid for the bonds and the BOE then throws the bonds into the shredder or does an rm -rf on the directory where the bond files are stored, or whatever the method might be that central banks use these days to send bonds off to debt heaven. The net effect is that the BOE just pulled £325 billion out of thin air and inserted it into the money supply. If you think this sounds crazy, this is exactly the method that was recommended recently by Jo Owen of the Financial Times:

Instead of selling the debt back into the market, the BoE can retire the debt. At a stroke, £325bn of UK government debt disappears. If the US follows suit, about $1.5tn of US government debt will be retired.

Mr. Owen then  goes on for the rest of the article explaining why this would be a good thing as long as certain 'preconditions' are met and how the BOE owned debt isn't 'real' anyway. He's right in a sense. Were the BOE to do this, not only would the £325 billion not be considered 'real debt', but the total remainder of the UK's sovereign debt (close to £600 billion)  would be rendered fake as well because the government and central bank will have just demonstrated that they are willing to print money to pay it off.

Keep in mind that there is no difference between what Jo Owen is proposing and what Robert Mugabe did when he printed up a bunch of Zimbabwean Dollars and used it to pay government worker's salaries or to add a new wing on to his palace or to pay for maintenance on his fleet of Benz's. Managing inflation expectations is almost as important, if not more so, for central banks than managing inflation itself. They do this by setting up complicated processes with terms like 'Quantitative Easing' and bombarding us with convoluted acronyms (there were no less than 9 acronyms created by the Federal Reserve during the 2008 crisis)  which all end up being just another way of funneling liquidity into the system. Mugabe's method was just much more efficient and obvious.