Sovereign CDS: It’s not (just) the economy, stupid | FT Alphaville

Sovereign CDS: It’s not (just) the economy, stupid

Felix Salmon points us in the direction of this post, from A Credit Trader, discussing the recent blow-out of US CDS to above 100bps.

Conventional commentary will tell you that this means the market thinks the chance of a US default is increasing. The country’s economic fundamentals are deteriorating, making the cost of protecting against a default more expensive. Another line on the above is that US CDS is a stupid idea anyway since if America were to default, it’s unlikely that CDS will be honoured in the post-apocalyptic financial climate. In any case, here’s Credit Trader’s take-down:

… one shouldn’t look at CDS as a “default” trade. Though their pricing is clearly driven by the likelihood of default and the payout upon default, I can tell you that 99% of people buying CDS do not believe that the entity upon which they are buying protection will actually default. In this, they are similar to investors in stocks. People buy and sell stocks because they think the stock in question will increase or decrease in price. Same goes for CDS.

This is a point that is (slowly) sinking into the wider market, as evidenced by a rather large piece of UBS research out this Monday morning.

The bank’s European Economics team, led by Stephen Deo, are examining the recent widening in the region’s sovereign spreads in a note entitled ‘How serious is Europe’s sovereign issue?’ Here’s the nut of the problem as UBS sees it (emphasis FT Alphaville’s):

When markets move, the pavlovian reaction of economists is to look for a fundamental explanation. This was our reaction as well. And indeed the sovereign spreads surged when it became clear that the deepening effects of the ongoing crisis would have damaging effects on the sustainability of public finances. We tried to explain the behaviour of spreads only by fundamental variables. We used fiscal variables such as level of debt, deficit, debt service, structural deficit, cyclical deficit, and many more. We also used macroeconomic data to gauge the performance of the underlying economy (GDP growth, unemployment rate, inflation, GDP volatility, GDP per cap, all types of leading and cyclical indicators, etc…). The results, frankly speaking, are appalling.

Instead, the bank began looking at the correlation between CDS spreads and risk aversion.

By contrast, we find a very high correlation between the behaviour of spreads during the last half year and the behaviour of risk aversion, which we proxy using the “UBS Global Risk Indicator”.

We thus conclude that the recent surge in sovereign spreads is not only a function of deteriorating fundamentals, but also a function of a widespread increase in risk aversion in all markets.

Following this idea, we fit a “UBS sovereign spread model” model that confirms that about two-thirds of the sovereign spread increase is due to risk aversion.

To wit, the charts below. They show the impact of S&P downgrades on European sovereigns’ spreads over Germany in 2002, 2004, 2008 and 2009.

Click to enlarge - UBS: Downgrade penalties

The de facto ‘penalty‘ for a downgrade increases from 5.2bps in January 2008 to 21.1bps in January 2009. So for the same increase in risk, i.e. one downgrade, the market is demanding a return four times larger than just a year ago. Something else has changed besides the economic fundamentals.

Looking a little bit more into the details, we actually find that 2008 is quite unique. In economists’ parlance, we call that a “regime shift“. Regime shift is an instance in which the behaviour of a market or a price changes. This is what happened with sovereigns.

The follow-through would be that as risk appetite increases, sovereign CDS spreads should start falling, regardless of the economic conditions. Of course, there’s a strong argument to be made that we are unlikely to get a decrease in risk aversion without a significant improvement in the economy, the two are considerably – perhaps intrinsically – intertwined, but the message on sovereign CDS should be fairly clear.

Put simply: It’s not (just) the economy, stupid.

Related links:
US CDS above 100bps: it’s a MAD MAD MAD MAD World!
– A Credit Trader
Credit protection madness
The mystery meaning of sovereign CDS
– FT Alphaville