Lately more and more investors have been asking the same question: why are traditional metrics of market stress and credit supply not indicative of what the market is doing? In particular, they look at the VIX index as well as 3 month LIBOR, which, last time around exploded when the market reached its post-Lehman lows in November. Why should it be different now, when the market reached a 12 year low last week and financial company CDS levels hit all time wides, yet both the VIX and LIBOR have barely budged?



It is gradually becoming evident that the primary culprit for this strange behavior is likely the government itself with its recent policy change to guarantee virtually all short-term markets, especially in credit (via its alphabet soup of recently instated programs). And the market has responded appropriately by pushing sovereign risk to record highs, not only in the U.S., but in other systemically critical countries that have also taken on liability guarantee programs such as Germany and the U.K.



The transfer of default risk to the sovereign's balance sheet is a novel phenomenon (at least in capitalist societies) and over the past 3 months traders have been scratching their heads on how to trade this. The only logical trade that has emerged has been purchasing credit protection in sovereigns as spreads have tightened in companies that are either explicitly named as too big to fail or are in industries affiliated with them. At latest count, the largest guarantees were within the financial, insurance and automotive space. As the Moody's thesis plays out and any number of the upcoming companies with near $300 billion in cumulative debt accelerate their bankruptcy filings, it is inevitable that the government will increasingly assume more and more risk to prevent the wholesale closure of the U.S.