Credit derivatives markets appeared to grow even more upbeat on Wednesday, but signs of unease were bubbling beneath the surface.
Closely-watched indices of credit default swaps, which have fallen sharply in recent weeks, continued to tighten, with Europe’s iTraxx Crossover dropping 6 basis points to about 537bp.
However analysts cautioned that short-covering was responsible for much of the movement — and warned that fundamental risk appetite remained extremely low.
“We were staring into the abyss about three weeks ago — the short base was very entrenched,” said Barnaby Martin, strategist at Merrill Lynch. “[Now] you’re seeing a huge short squeeze.”
Mr Martin added that cash bond indices had barely moved in recent weeks, with many bonds still trading at very wide spreads.
Illiquidity in cash bond markets may contribute to their divergence from credit derivatives, but some analysts say these bonds may still give a truer picture of investor appetite for risk.
Folkert Jan Van Der Veer, bank analyst at Dresdner Kleinwort, believes the CDS market has over-reacted in recent weeks. “If you speak to investors, risk appetite is very, very limited. Quite a few investors burnt their fingers in September - so now they are very reluctant to participate in the [credit] market.”
And don’t forget the broad economic picture, analysts at BNP Paribas remind us:
It is not the first time we hear calls that the markets may have bottomed, and we believe it will not be the last in this cycle. With only half of the expected losses from subprime mortgages in the open - not to mention those related to other asset classes - announcements of writedowns will probably continue well into 2008, and with them the deleveraging process that is currently underway. The one-way rally we have recently seen is unlikely to be sustained.
The iTraxx Europe, which measures the cost of protecting 125 investment-grade credits against default, fell 3bp to about 109bp. This means it cost €109,000 per year to insure €10m of iTraxx Europe debt over five years.
