Carnage. We’ve become inured to days of extreme volatility in the credit markets but today was extraordinary even by recent standards. The Markit iTraxx Europe index was trading at 146bp, an astonishing 26bp daily move. It closed at the paltry level of 134bp. The Markit iTraxx Crossover was 80bp wider at 620bp and is currently trading at 600bp, “only” 60bp wider. The Markit VolX Europe, which measures 20-day volatility in the Markit iTraxx Europe index, now stands at 83%. At the beginning of April it was just 39%.
The markets opened this morning even more nervous after the chaos in the US stock markets. Spreads widened in monumental moves reminiscent of the post-Lehman days and the weeks of the banking crisis in early 2009. There was a lack of news flow around sovereigns but this only made matters worse. The markets have come to the conclusion that the status quo is unsustainable and radical policy action is needed. An announcement from the ECB and/or the G7 was expected. The latter group reportedly held a teleconference this afternoon but nothing concrete was revealed. The ECB was silent (more of that later).
So sovereigns were again driving the broader credit markets wider? Not exactly. For once, the Markit iTraxx SovX Western Europe index outperformed its corporate cousin, though it experienced another tumultuous day. The index closed at 169bp, only 3bp wider than yesterday. But it opened 16bp wider at 182bp, the fears of contagion still keenly felt. Greece traded above 900bp for most of the day and most of the other peripherals fared better, making small gains in some cases.
The sovereign crisis made itself felt though an ancillary channel. Banks have been under severe pressure this week and it became more intense today amid fears that the sovereign contagion could infect the financial system. It was all too clear last year that banks require the backstop of the state to exist in times of crisis. If the solvency of the government is in doubt then that clearly threatens the viability of the domestic banking system. The cross-border links between banks in the eurozone are well-known, and investors have been scrambling to figure out what institutions have most exposure to the periphery.
The Markit iTraxx Senior Financials index widened beyond 200bp today, the first time it has done so since the dark days of March 2009. The correlation between sovereigns and financials is clear from the chart above. it also shows that the differential between the Markit iTraxx Europe and the Financials index has increased significantly in recent days, highlighting the vulnerable state of the banking sector.
An inconclusive general election in the UK added to the febrile climate. A hung parliament was the worst possible scenario for investors looking for a new government that will take decisive action in cutting the country’s ballooning deficit. Even though opinion polls have been predicting this outcome, it was not necessarily expected by many in the markets, with the betting exchanges forecasting a small Tory majority. The UK‘s CDS underperformed the broader sovereign market today, going beyond the 100bp mark and reaching its widest level since April 2009. It had held up relatively well compared to its eurozone rivals. More volatility can be expected while the three main parties try to form a government.
But the week did end on a positive, if tenuous note. Spreads tightened sharply late in the session amid rumours that the ECB is preparing special liquidity lines to shore up the banking system. The speculation gave bearish investors an excuse to cover their shorts in case there is an announcement over the weekend. If nothing materialises then we can expect another wave of volatility early next week.
Markit’s Gavan Nolan wrote this CDS report