Sovereign CDS Are On The March Again
With today's news out of Ukraine, which may or may not be a dud (although with the economy hardly functioning courtesy of massive quarantines and business shut downs) sparking off what may or may not have been a a huge dollar squeeze (we are still waiting to hear back from the ICE), one observation is that sovereign CDS spreads are back front and center. As we discussed recently, Japan CDS has been ploughing ever higher, yet recent data indicates that the deflating island nation is not alone.
We present some recent commentaries out of Credit Research which demonstrate that the sovereign balance sheet risk trade may be coming back with a vengeance, now that currencies and macro are all the rage (Bernanke has succeeded in killing micro alpha strats). And when everyone is on the same side of the FX trade, the only place left with some liquidity is, as always, CDS.
Sovereign Risk Continues to Rise (from 11/19/09)
Sovereign risk continued to rise this week as all index members except Japan added risk. The CDR Government Risk Index (GRI) broke through the fifty basis point mark this week for the first time since late July, making its tight range of the past few months a thing of the past. As we noted last week, Japan experienced a run up in risk even as the other majors rose only modestly. This week, Japan rallied while all other index members deteriorated. Since October 1, the GRI rose by about twenty-five percent. However, clear winners and losers emerged in that time period. Germany barely budged off its previous levels and France is modestly riskier. Spain and Italy, the riskiest members of the index, are both up about twenty percent while the USA, the UK and Japan all trade riskier by over forty percent. After last week's moves, the USA and Japan saw their CDS rise by the same amount on a relative basis over the past two months.
As the financial crisis kicked into gear in the fall of 2008, the GRI lagged corporate credits (and financial credits in particular) as risk skyrocketed. This autumn, the sovereigns lead the way wider. If the trend wider continues, then we would interpret that as the market taking a view on rising systemic risk. In other words, a continued rise in the GRI is an early warning sign that market participants expect a stall in global economic recovery and we would expect corporate credit (and equities) to deteriorate. An even-wider GRI in December would be a grim portent for 2010.
Sovereign Shenanigans (from 11/13/09)
Sovereign risk rose dramatically among the European majors, even though Eurozone GDP rose (ok just!). We see two drivers of this building on themselves: the first is the weakening USD which exaggerates the spread needed to cover a constant non-USD amount of foreign (non-USD) sovereign debt, and the second is more idiosyncratically related to either government leverage (think debt/GDP or Debt/Tax Receipts) or implicit guarantees. The latter was the most notable idiosyncratic driver today in European sovereigns as Dexia's results looked reasonable at first glance but comments by the CEO regarding ongoing 'negotiations' with the Belgian and French governments over asset disposal and further capital spooked Belgium CDS 8bpsw wider to 44bps!
We discussed the bifurcation in the CDR GRI yesterday and today saw that divergence continue with Spain, Italy, and UK popping wider (dragged by Belgium contagion). SovX saw its largest one day rise of 4bps to 54bps today since inception (above the 10/03 previous wides) moving to its widest close since inception (remember SovX covers Western European soveriegns). The CDR GRI (a more broad/global sovereign risk index) moved back above 50bps (to 51.5bps), its widest level since 7/22.
A theme trade we have been 'waiting' for is the European corporates versus sovereigns decompression and this week has seen ITRX exFINLs compress almost 10bps to SovX. The differential now trades at around 32bps and once again represents one of those low cost long vol plays we like. Two additional points support this including ITRX ExFINLs is a little rich to intrinsics and the correlation (not we did not say dependence) between risk assets and the USD also play to this decompression as a cheap bet on a dollar rally. If the USD continues to weaken then the SovX underliers will widen (as constant non-USD asset values need more USD protection) and if the USD weakens then risk assets are seemingly strengthening via the carry trade - which will compress the differential. We think 32bps is a reasonable carry cost to pay for a cheap bet on a short-covering snap back in the USD.
Finally, in any seemingly sound world, where would you expect corporates (exFINLs) to trade relative to Sovereign risk? 32bps thru? hhmm...Also look at ITRX LoVol relative to SovX!! now trading within 3bps of one another - seems like a cheap decompression bet.