Double-Dip Recipe

As I see it, the recipe for a double-dip recession is a simple one.

The supposed recovery, which we’ve doubted every step of the way, has happened on government stimulus and bail-outs distributed by bought-off politicians to their private sector cronies. Those politicians refuse to raise taxes for fear of losing their jobs. That leaves the game vulnerable to a bond market upheaval that sends interest rates higher and stops the hands of government money-throwers.

Said money-throwers would have no choice but to cut spending and raise taxes, precisely at the worst possible time to do so. The move could bring the second half of the recession. That’s why any ripple in bond markets, but especially in sovereign bond markets, gets stock investors bent out of shape.

What’s more, the same forces that contributed to the collapse of 2008 are working hard to cause and benefit from the next collapse. How? By buying credit-default swaps (CDS), which are insurance against a bond going bust, when they don’t even own the bond in the first place. That’s called “naked” buying. Naked buyers of CDS want to own only the insurance policy against a bond going bust, and collect when it does. Well, what happens when people want to buy the same thing? Its price rises.

Last week, the price of CDS on bonds out of Greece et al. rose like mad. The price of the cost to insure against default is used as a measure of the safety of the underlying bond and, by extension, the bond issuer. If the cost of insuring against Greece defaulting goes through the roof, we assume that Greece is in trouble. Few inspect the cause for the insurance price spike. That’s how enough institutions buying the CDS can drive up the prices, cause fear around the bond issuer, lead to downgrades of its debt, and start the cascade that fulfills the prophecy of having bought the insurance against default.

It happened in 2008, and it’s happening again. Watch carefully.

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