There is much speculation of short-selling bans in one or more European equity markets at pixel time. An old fear in the credit and fixed income markets trading the sovereigns, of course. An old fear with a deeply ironic effect on sovereign CDS at the moment…
Thing is, spreads are widening. Italy and Spain CDS have even converged (chart via Markit’s Lisa Pollack):
(You’ve all seen the similar widening in France and Germany CDS)
We’ve noted the divergence between bond yields and CDS prices before.
Again, Italian and Spanish bond yields are falling, but the CDS continues to blow out. An interesting move and you may think it’s an indictment of the ECB’s bid to stifle sovereign volatility with its buying. You could also take it as a sign that markets are pressing French and German credit as underpinnings of the euro.
Connected to this, Alan Ruskin of Deutsche Bank posted the chart below on Thursday, noting CDS-rating discrepancies in core credit:
Ruskin also notes that the ECB purchases might have pushed the hedging of sovereign risk back into the CDS market. Certainly it’s febrile out there.
Well… the current size of the dislocation is just a tad more technical than that, possibly. But it’s revealing all the same. It’s febrility feeding febrility. More to the point, this is a basis effect.
Here’s what seems to have been going on. A few in the market are currently keen to promote a certain eurozone sovereign trade…
The trade is supposed to targeted toward a positive basis in bonds and CDS. That is, sell bonds and sell CDS to (eventually) watch the spreads converge. For example — France’s bond spread has been about 100bps tighter than the CDS, which is going nuts if you hadn’t noticed. Now the thing with any positive basis trade is that CDS very rarely pushes bonds wider (despite politician logic). So it’s a difficult bet at the best of times.
There are three particularly awkward problems right now, however.
Shorting bonds
Firstly, no one is shorting bonds alongside those putting on these trades. We’ve heard that one big factor here is that real money in Germany at least (and possibly in France and Austria) is either unwilling or unable to short sovereign bonds because of regulator pressure. Moreover, by this point there is a massive central bank balance sheet standing in your way in particular markets such as Italian or Spanish debt. Note the self-censoring of the shorts.
Selling CDS
No one is joining in on the next component of the trade either. It’s possibly because the real money again has been wary of regulator pressure, this time over indirect exposure to the periphery that is thereby placed on to books by swaps. Possibly, it’s because of this long-run view that sovereign risk is out of control in the eurozone, and quickly infecting the core sovereign credits. Therefore you’re going to avoid selling CDS anyway if you simply expect it to widen over time (and you are, perhaps, already sat on a pile of periphery bonds). In any case the market is thin.
Buying CDS
No one is on the other side of your trade either, and this is maybe the coup de grace. Few are prepared to buy CDS at the moment. That’s both because of the failure to derive a credit event from the recent Greek financing offer, and because of persistent wariness that buying CDS will be banned as a specie of evil, dirty anti-Europe shorting. QED – there is no market, and when there is no market, spreads continue going up. Thus the positive basis trades sees the odds stacked even more against it. Ghastly. The end.
In the grand scheme of things, the blow-up of this trade doesn’t amount to very much at the systemic level, both in terms of the exposure outstanding and the dynamics of the trading. (It’s the opposite of the usual regulator fears over CDS systemic risk, i.e. that morons are writing CDS protection that they can’t back with cash. Not the case, and not implied by net notional.) As noted, it’s a difficult trade anyway.
Still, in case you were in any doubt that the market is febrile, even broken, and liable to send out very mixed signals on sovereign risk currently — actually this is a good example.
Caveat (CDS) vendor…
Related links:
The hot new Greek basis trade – FT Alphaville
Fund managers flee euro zone financials - Reuters