Sovereign CDS

A peculiar trading session, in which the usual overnight futures levitation has not been led by the BOJ-inspired USDJPY rise (even as the Nikkei225 rose another 0.6% more than offset by the Shanghai Composite drop of 0.86%), which actually has slid all session briefly dipping under 99 moments ago, but by the EURUSD, which saw a bout of buying around 5 am Eastern, just after news hit that the UK would avoid a triple dip recession with Q1 GDP rising 0.3% versus expectations of a 0.1% rise, up from a -0.3% in Q4 (more in Goldman note below). Since the news that the BOE will likely delay engaging in more QE (just in time for the arrival of Carney) is hardly EUR positive we look at the other news hitting around that time, such as Finland saying that the euro can survive in Cyprus exits the Eurozone, and that Merkel has rejected standardized bank guarantees for the foreseeable future, and we are left scratching our heads what is the reason for the brief burst in the Euro.

It is one thing for the market to no longer pay attention to economic fundamentals or newsflow (with the exception of newsflow generated by fake tweets of course), but when the mainstream media turns full retard and comes up with headlines such as this: "German Ifo Confidence Declines After Winter Chilled Recovery" to spin the key overnight event, the German IFO Business climate (which dropped from 106.2 to 104.4, missing expectations of 106.2 of course) one just has to laugh. In the artcile we read that "German business confidence fell for a second month in April after winter weather hindered the recovery in Europe’s largest economy... “We still expect there to have been a good rebound in the first quarter, although there is a big question mark about the weather,” said Anatoli Annenkov, senior economist at Societe Generale SA in London." We wonder how long Bloomberg looked for some junior idiot who agreed to be memorialized for posterity with the preceding moronic soundbite because this really is beyond ridiculous (and no, it's not snow in the winter that is causing yet another "swoon" in indicators like the IFO, the ZEW and all other metrics as we patiently explained yesterday so even a 5 year old caveman financial reported would get it).

The debate about the usefulness of sovereign credit default swaps (SCDS) intensified with the outbreak of sovereign debt stress in the euro area. SCDS can be used to protect investors against losses on sovereign debt arising from so-called credit events such as default or debt restructuring. With the growing influence of SCDS, questions arose about whether speculative use of SCDS contracts could be destabilizing - and this caused regulators to ban non-hedge-related protection buying. The prohibition is based on the view that, in extreme market conditions, such short selling could push sovereign bond prices into a downward spiral, which would lead to disorderly markets and systemic risks, and hence sharply raise the issuance costs of the underlying sovereigns. The IMF's empirical results do not support many of the negative perceptions about SCDS. In particular, spreads of both SCDS and sovereign bonds reflect economic fundamentals, and other relevant market factors, in a similar fashion. Relative to bond spreads, SCDS spreads tend to reveal new information more rapidly during periods of stress, admittedly with overshoots one way or the other. Given the current apparent 'stability' in many nations' bond market spreads, the chart below suggests an alternative way of judging what the credit market thinks - the volume of protection bid - and in this case some interesting names emerge.

Many have argued that sovereign CDS markets 'caused' the problems in Europe - as opposed to simply 'signaled' what was in fact being hidden by cash market manipulation. But as the IMF notes in a recent paper, there are times when the CDS market leads the cash bond market and other times when it lags. But as far as looking at risk in Europe and the US, based on a wonderful model that uses Markov-switching to predict what the probability of the world being in a low-risk or high-risk state, we are as 'low risk' as we have been since the crisis began. Each time that level of complacency was reached before, equity markets have rapidly sold off. What is perhaps most notable is the systemic compression of every risk indicator, first VIX (Kevin Henry and the fungible excess reserves of every prime dealer whale), then the liquid SovX index (via Greece CDS auction uncertainty and 'naked' short bans), then the Euro TED Spread (via LTRO), then individual Sovereign CDS (via Draghi's 'promise'). The result, the 'free-market' signal of risk is non-existent.

Now that the 3:30 pm pump has been exposed to the world, and having been priced in and frontran (such as yesterday) it changed to the 3:30 dump, algos are desperately searching for another daily calendar trading opportunity. It appears the opening of Europe and Japan for trading are just these two much needed "fundamental" catalysts. As the charts below show, it appears there is nothing more bullish for the two key carry pairs, the USDJPY and the EURUSD, than Japan opening at 8pm Eastern, and then Europe opening next, at 3:30 am Eastern.

The driftless overnight sessions are back. After the Nikkei soared by 3% following several days of declines, and the Shanghai Composite continued its downward ways despite Non-Manufacturing PMI prints for March which rose both per official and HSBC MarkIt data, Europe was unsure which way to go, especially with the EURUSD once more probing the 1.28 support level. The USDJPY was no help, and even with the BOJ meeting at which new governor Kuroda is finally expected to do something instead of only talking about it, imminent, has hardly seen the Yen budge and provide the expected carry-funding boost to global risk. In terms of newsflow there was little of it: European CPI in March printed at 1.7%, above expectations of 1.6%, but below February's 1.8% rise in inflation. UK continued telegraphing the inevitability of Mark Carney's imminent QE, with construction PMI the latest indicator missing, at 47.2, below expectations of 48.0 (above 46.8 last).  Elsewhere, Spanish Prime Minister Mariano Rajoy on Wednesday called for Europe to implement growth policies to balance its austerity drive and for countries with room for fiscal manoeuvre to increase public spending. "Europe is the only region in the world in recession. To overcome this situation we need three things: every country needs to do its homework, we need more (European) integration and we need growth policies," Rajoy said in a televised speech to leaders of his People's Party. "That's why countries which can afford it should spend more." Surely Europe will get right on it: after all, it's only "fair."

It started overnight in Japan, where Q4 GDP posted a surprising and disappointing 3rd quarter of declines, then quickly spread to France, whose Q4 GDP declined -0.3% Q/Q missing expectations of a -0.2% drop, down from a +0.1% increase, then Germany, whose GDP also missed expectations of a -0.5% drop, declining from a +0.2% increase to a -0.6% drop, then on to Italy (-0.9% vs Exp. -0.6%, last -0.2%), Portugal (-1.8%, Exp. -1.0%, last -0.9%), Greece (down -6.0%, previously -6.7%), Hungary (-0.9%, Exp. -0.3%), Austria (-0.2%, down from 0.1%), Cyprus (-3.1%, last -2.0%), and so on. To summarize: Eurozone GDP dropped far more than expected, or posting a -0.6% decline in Q4, worse than the -0.4% expected, which was the largest drop since Q1 2009, and down from the -0.1% posted in Q3. And since this was a second consecutive negative quarter of GDP decline for the Eurozone, the technical recession (double dip? triple dip? is anyone even counting anymore?) in Europe too is now official.

With JPY bleeding lower once again overnight extending to 28-month lows against the USD (and the long-end of the JGB curve starting to show some signs of anxiety), it is perhaps timely to revisit Kyle Bass's five key reasons why Japan is the epicenter of the world's failed monetary policy experiment. In this excellent and much-requested summary 8-minute clip, Bass summarizes his Japan thesis and destroys several of the myths that talking-heads like to assign to the so-called widow-maker trade.

Yesterday we presented Goldman's first 3 Top Trades for 2013 as they come out, while also noting Goldman's recent disfatuation (sic) with gold. Today, we present Goldman's 4th Top Trade for 2013, which is, drumroll, to go long Spanish Government Bonds, specifically, the 5 year, which should be bought at a current yield of 4.30%. with a target of 3.50% and a stop loss of 5.50%. This reco comes out after the SPGB complex has already enjoyed unprecedented gains - but not driven by economic improvement, far from it - but merely on the vaporware threat of ECB OMT intervention. Of course, once the "threat of intervention" moves to "fact of intervention", everything will promptly unwind as it always does (QE was far more potent as a stock boost when it was merely a daily threat: the market's peak not incidentally occurred the day after Bernanke dropped his entire load: one simply can't move beyond infinity). And with Spain's massive bond buying cliff in Q1 2013, the days its bailout could be postponed are coming to an end.

It was a week ago when we first observed that the defense of 1400 in the ES at all costs must go on, or else the only thing that is keeping the market propped up - psychology (now with the AAPL euphoria long gone), would be gone as would all support. But once again, the overnight session has proven that, with a little help from its central banking friends, 1400 (and 1.2900 in the EURUSD) can be defended. This was in danger of being breached until China reported two PMI numbers: an official one which printed at 50.2, or modest expansion, and up from 49.8, magically right on top of expectations of 50.2, and the HSBC PMI, which also rose to 49.5, from 47.9: the 12th straight contraction print, but the highest number in 8 months. The market spin is naturally that this is an indication of a rebounding China. Sadly, just like in the US, this is merely pre-party congress data manipulation. The only thing that does matter out of China: whether or not the country will actually ease as opposed to doing day to day reverse repo injections. Without the former, the Chinese economy will not rebound, and will not lead to an improvement in corporate outlook for US tech stocks, period, the end.

Since the rumors and news of the Sovereign CDS ban began in Europe (due to officially be in place next week), sovereign CDS spreads (and their gross and net exposure) have been crushed. This would seem like a good thing for all the standard CDS-haters and speculator-blamers who believe that Europe's problems were 'caused' by these mean credit traders; but bonds haven't followed. Bonds have rallied but this is more consequence of front-running Draghi's OMT than CDS compression. The concern is, should we see a risk flare, the CDS market (and its basis traders) will not be there this time as a natural buffer (or protection provider) this time. Exactly as we noted here, the unintended consequence of regulating away the CDS market will be higher costs of funds as real-money will be considerably more risk averse in an unhedgeable event risk market - and we are already seeing exactly this in Spain.

Much is being made of the compression in Spanish bond spreads this week - the largest 3-day drop since Draghi's 'dream' speech. Four critical things come to mind: 1) increasing amounts of Spanish sovereign debt is now held by domestic banks, making the market less liquid (and far less transparent as any indication of 'reality'); 2) the ban on naked CDS (and Draghi's put) has created a hedging vacuum with CDS spreads collapsing and exposure slumping (technically dragging bond risk down); 3) Lower spreads reflexively mean lower probability of Rajoy saying "Si" - which is what is helping spreads compress (leaving event-risk high - as indicated by the outperformance of our legal arb trade); and perhaps most importantly 4) Recency bias is incredible - we have seen 100-plus percent rises in Spanish risk followed by 35-plus percent retracements a number of times and the current level of Spain risk is still above LTRO-inspired crisis levels. So let's not get all excited quite yet eh?

The fact that the major credit indices have had to resort to 'imaginary credit' in order to generate an actionable market is perhaps the final nail in the coffin of the single-name CDS market in this cycle. An artificially low spread environment, forced their by massive technical flows thanks to central-bankers' financial repression has removed a natural buyer- and seller- from the market - reducing liquidity; and combined with Dodd-Frank and more regulation (higher capital reqs), dealers are also forced to delever risk books (reducing liquidity). But, there is one glaring reason why the single-name CDS market is dying; extremely high correlation. As Barclays notes, in a market where investors’ ears are, more than ever, finely tuned to the statements of politicians and central banks and the tail outcomes for the market, it makes sense for correlation to be high – at this stage, there should be little distinction between individual names – trading the level of systemic risk premia is the focus. And sure enough, index (systemic) volumes is rising as single-name (idiosyncratic risk) trading volumes and exposures are fading fast. So what brings it back?

It is hard to find fiscal situations that are worse than Japan's. The gross government debt/GDP ratio, at more than 200%, is the worst among the major developed economies. Yet yields on Japanese government bonds (JGBs) have not only been among the lowest, they have also been stable, even during the recent deterioration during the European debt crisis. This apparent contravention of the laws of economics is both an enigma for foreign investors and the reason for them to expect fiscal collapse as a result of a sharp rise in selling pressure in the JGB market. As Goldman notes, the European debt crisis has led to an increase in market sensitivity to sovereign risk in general and questions remain on when to expect the tensions in the JGB market and the fiscal deficit to reach a breaking point in Japan. In the following 14 charts, we explore the sustainability of fiscal deficit financing in Japan and Goldman addresses the JGB puzzles.

We have long warned that the effects of a ban on 'free-market' hedging instruments could well have a negative impact on the underlying market that political leaders are 'trying' to protect (consider the fall in equity prices after the short-sale-bans) and this week brought some clarity with regard Europe's Short-Selling-Regulation (SSR) on CDS. As Citi's Matt King notes: "the technical standards underlying its short selling ban reinforce the view we held previously: the ban seems likely to add to selling pressure on cash bond spreads in peripherals, even if it brings down CDS and tightens the basis." The SSR defines 'naked' as CDS that are 'highly correlated' with long bond positions, but bonds have only tended to be quite correlated to their own CDS at periods of low volatility, and this correlation breaks down over sell-offs, which is precisely when hedging is needed most. This will leave portfolio managers unlikely to want to rely on sovereign CDS hedges (which they may now be forced to unwind at any moment) and presumably means they will be reluctant to take out initial long positions in both peripheral sovereigns and corporates in the first place - reducing demand for cash bonds. Once again - regulators and politicians should be careful what they wish for.