As the start of the week is spiced up by the news surrounding the problems with the US, and the Italian Bonds - the largest and the third largest fixed income markets in the world respectively, it may be instructional to look at the framework developed by Enrico Fermi, the famous Italian American physicist.
In 1950, while working at Los Alamos National Laboratory, before the start of one lunch session, Fermi asked his fellow physicists: “Where is everybody”? He was referring to alien life forms. He proceeded to give a detailed mathematical explanation why we should have spotted aliens by now. His mathematical framework had two components. The first component was the “Argument of Scale” – there are billions of stars and planets in our Galaxy. The second component was the “Argument of Probability” – there is a very low chance of life evolving into an advanced species capable of undertaking intergalactic travel. More importantly, there is no way to have an idea of what that probability should be, since there have been no past observations.
The above framework helps us to elegantly organize our ignorance on any problem of massive scale. Sometimes, even by organizing our ignorance, we are able to form a better judgment on the future course of events.
Applying the above framework to the risk of default by a major sovereign, it is a given that the Scale Component of the Fermi Analysis is huge for both the USA and Italy. Coming to the probability, –which the world has not witnessed, in the recent past, of credit risk emanating from major world powers, - the average market player has no idea how much importance should be given to the risk of default and how the probabilities would evolve as events unfold surrounding the credit risk.
Given the above framework, we believe that the market response to the unfolding credit risk drama would be disjointed, and unpredictably volatile. We may be forced to ask the question “Where is everybody?” when we may spot that the reactions of sellers of bonds is significantly muted to some major credit events. We may be forced to ask again “Where is everybody?”, when we see that buyers are on strike as a reaction to a seemingly minor credit event. Just to repeat, it would suffice to keep in mind that most of us do not have a ready framework for analyzing the credit risk evolution of major super powers, and this ignorance, coupled with the scale issue, will make the responses unpredictable.