Add one to the list of Greece CDS-speculator exonerators: Fitch Solutions
The rating agency offshoot has done a study with a slightly different focus; CDS liquidity, a measure of market uncertainty and demand for the credit default swap contracts, as opposed to pure CDS.
The Fitch verdict: it is Greece’s economic fundamentals that have been forcing its bond yields higher, not CDS.
Fitch’s Developed Market Sovereign Index has become increasingly liquid (i.e. with a lower liquidity score) over the last few months, as sovereign concerns generally equate to more market stress.
Interestingly however, there was a brief period in the summer of 2009 when liquidity on Greek CDS diverged from the Developed Index; it became more liquid (the liquidity score moved relatively lower):
Was this the speculation much-maligned by Greek authorities and others?
Sort of. On a contract-by-contract basis, liquidity shifted into the US dollar-denominated CDS contract in June 2009. Increased liquidity in euro-denominated contracts might have suggested some genuine hedging, given most Greek debt is in euros — but not so much USD contracts. Someone was betting.
Here’s what Fitch says:
However, in June 2009, liquidity shifted back to the US dollar, which coincided with a significant increase in liquidity on Greece — as shown in the circle in Chart 3. So, what is behind both the sudden increase in liquidity and the shift to US dollar contracts? Chart 4 [below] shows the liquidity score on Greece against the Greek five-year bond yield over the Bund — a proxy of the risk-free rate. It highlights that during the period when the CDS on Greece showed a significant increase in liquidity between June and August 2009, bond yields were actually falling. Falling yields may explain a drop-off in direct hedging activity, hence less demand for euro contracts. But why did liquidity in the US dollar contract increase?
Earlier in 2009, five‐year Greek bond yields above the Bund were over 3%, but by May they had fallen to below 1.5%. Given that during this period there were no dramatic improvements in the fundamentals of the Greek economy, it is plausible that several CDS market participants felt that the steady narrowing of Greek government bond yields made little sense when they analysed market fundamentals. If a number of active investors felt that yields were likely to rise, they may have also been concerned that such a widening of yields might cause the euro to depreciate against the US dollar. Thus they would have been more likely to take these active bets in Greece CDS in US dollars rather than euros.
So crucially, even if there were some bets against Greece going on in summer 2009, heightened CDS liquidity did not coincide with rising bond yields; in fact it coincided with lower bond yields.
Presumably market players were working on the assumption that those narrowed yields were unsustainable given Greece’s fiscal situation. Something was mispriced in the market
The movement is even clearer in Chart 4 (below):
So between June and August of last year, when Greek CDS liquidity was rising, bond yields were falling. In December 2009, when bond yields were increasing, liquidity was declining. Only in March/February did the two things actually appear to be rising in tandem.
But, as Fitch cautions:
. . . given liquidity on Greece CDS was only marginally higher than in the summer of 2009, the claim that the CDS market was driving yields in January and February 2010 does not appear to hold.
And so to the conclusion:
The above study shows that during a period of increased liquidity for Greece in the summer of 2009, the cash bond market was driving yields down, causing CDS spreads to narrow. The surge in liquidity was most likely caused by a number of active investors who did not believe that yields on Greek bonds were sustainable at such low levels and who also thought that the euro might be impacted by any potential widening of yields. In January and February 2010, bond yields widened dramatically as did CDS spreads, yet liquidity on the CDS was no greater than it had been in the summer of 2009 when it clearly had no impact on price formation. Moreover, the divergence of the euro and the US dollar contracts was also a forewarning of a depreciating euro against the US dollar, and of a stronger impact on any possible default of Greece on the euro itself. This highlights that it has been fundamentals driving yields wider and not CDS contracts.
Related links:
The benefits of naked CDS – FT Alphaville
Trojan speculators, or, one headache for the Greek authorities – FT Alphaville
Greece vs everyone, BaFin and speculators edition – FT Alphaville
On the non-existent basis of a (Greek) CDS ban – FT Alphaville