Did Basis Traders Save The Euro-Zone (For Now)?

Tyler Durden's picture

While the standard run-of-the-mill hedge fund trader has been vilified as a short-selling scoundrel, we have pointed again and again to the sometimes impressive and impactful effects this rabble of speculators can have. In the US corporate bond market last year and early this, CDS-Bond basis traders were often the busiest providers of demand at bond auctions (since concessions were solid and this trade somewhat locks that gain in). These buyers-of-bonds simultaneously buy CDS protection to capture carry at a potentially lowered risk and look to profit from bond and CDS pricing converging.

During the middle phases of the Greece debacle this year, it was basis traders that dominated any trading of GGBs as they stood in the middle and captured the spread - providing some liquidity to the Greek bond market at a difficult time. As soon as policy-makers started to 'sanction' CDS and work to circumvent them, GGBs exploded as event risk became too much for the 'basis' traders who looked for the exits.

The last week has seen very impressive rallies in many of the most stressed European sovereigns - most notably Italy, Spain, and Portugal. This rally coincided with the basis between bond and CDS prices being extremely wide. Since the middle of the day on 11/30, the basis has compressed dramatically as bonds have handily outperformed CDS. What worries us now is that the basis has reached 'expensive' relative levels and if we see basis traders withdraw (or take profits) then the ECB will be shouldering even more of the load.



The underperformance of European sovereign bonds relative to CDS (as real money looked to reduce exposure to these albatrosses as opposed to hedge in a market that policy-makers are clearly trying to subvert) caused the spread between CDS and Bonds to reach well over 2 standard deviations cheap in the case of Spain, Italy, and Portugal (see above chart). In the chart we see the basis for each of the sovereigns drop below the lower 2 standard deviation band (red ovals) at which point basis traders stepped in in size.





The last few days has seen the basis compress dramatically (from around midday on 11/30) as we suspect basis traders were just too tempted to grab at what was very cheap carry. This trade which buys bonds (optically improving the market's perception of reality) and buys protection in the CDS market at the same time (less clear to most and less discussed unless it is exploding) has performed extremely well as it seems the market was desperate for a real buyer and hope resumed.

This is great but unfortunately the basis has reached back up to relatively expensive levels (upper chart bands) and with the potential for dramatic moves and dislocations around the next summit this week, we suspect basis traders will keep some powder dry - or more likely be looking to flatten positions a little with a good profit.

As we stand, Spain bonds look the most expensive, followed by Italy, and then Portugal (which remains curiously wide). If you were a betting man, being Short Spanish bonds and Long Italian credit via CDS (selling protection) on the back of potential basis unwinds may make
sense here.

Watching the CDS-Cash basis can offer some insight into reality - even as headline optics appear extreme at times. Today's CDS-Bond basis action suggests the unwinding process began as bonds underperformed and the basis dipped down for the first time in a week.

We also remind readers and policy-makers to be careful what they wish for with regard the nefarious CDS market as all too often, removing hedges has significant unintended consequences and in the case of basis traders, these impacts can be very systemically significant in a market with large crowds and small doors.

Charts: Bloomberg



UPDATE: By request here are the CDS spread and Bond yield charts for Italy, Spain, and Portugal over the past few months:

Italy - CDS initially outperformed 2-3 weeks ago (orange vs black thick solid lines) but since last week bonds have accelerated ahead of CDS. (note this is Bond Yield not spread so not directly comparable but the message/trend is clear).

Spain - CDS and Bonds moved simultaneously initially but the last week or so has seen CDS stabilize as bonds have outperformed. Note the red oval which shows the period post the previous EU Summit where CDS 'value' was questioned and spreads compressed significantly (but look at what bond yields did - they deteriorated).

Portugal - Portuguese bonds have been in a world of their own for a while. treading water nicely as all around them deteriorated and then exploding higher in yield. CDS (orange) was the first mover (like Italy) but the last week or so we have seen CDS widen as bonds have rallied on - compressing the basis.

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Ahmeexnal's picture

Idiots, they will be handed their balls on a platter.

TheSilverJournal's picture

Buying insurance against default makes no sense. If the fiat ponzi collapses, how do the buyers of the insurance think they will get payed?

Schmuck Raker's picture

Perhaps some view the world as not just black or white?

ebworthen's picture

Good question.

They bundle the insurance into swaps and have retirees, pension funds, municipalities, and mutual funds to buy it at AAA ratings.

When the ponzi collapses, the bill is passed to the central banks, who pass it to governments, who pass it to the average working citizen and their unborn children in the form of "austerity" and future debt.

It is an engineered form of theft, of skullduggery - using "economics" and "judicial process" and "banking" of supposedly educated and "moral" people in nice clothes to do the robbing.

In the old days the Czar or King or Shogun would have roving bands of mercenaries beat people over the head for tribute.

Isn't this better?

</sarc off>

Going Loco's picture

"They bundle the insurance into swaps and have retirees, pension funds, municipalities, and mutual funds to buy it at AAA ratings."

That is what I have been thinking. When I hear people like Hendry and Bass talk about their plays on collapse I always find myself thinking, who have they got as a counterparty that will still be able to pay if the event occurs? And the only answer I can come up with is that somehow the thing has been engineered so that their counterparties will have an automatic government backstop. Not saying these guys are wrong to do such a thing (if this is indeed what they are doing) but really that just gives us the same circular path to the same outcome which is that the middle class will pay for all this.

jm's picture

(Most) basis traders don't care about default and determination.  The basis trade is simply a short-long strategy on spread moves.

Maybe this is more about the effectiveness of bond purchases... once cash bond spreads or CDS premium stabilize at a line in the sand, then they drop out of the "default condition red" zone as basis traders then step in.  Then others like insurers follow because  markets can source liquidity again.

I admit this seems weird, because if there is no way to get an honest determination in sov default (aka the Greece haircut), there is no effective protection in a CDS position... no real "short" leg.  It becomes just another way of picking up pennies in front of a steamroller.  But everything else is exactly the same given a long enough timeline.

Manthong's picture

I don't understand it.

Doesn't the very concept of "voluntary haircut" make the whole damn process a theater of the macabre?



jm's picture

If you hold a bond, you fear default.  If the ECB comes in and buys secondary bonds (probably bought at auction through a SIV, and probably will have to take delivery on futures) with enough size to draw a line in the sand on spreads, it is a big signal. When the market tests resolve, and they are willing to be the buyer of last resort, then you lessen/marginalize default risk.

For buyers with a deep-seated belief in the near-equivalence of short CDS and long bonds, this is good enough because they care about spread moves.  When these guys step in arb the spread, then the rest of the ecosystem steps back in.  Is default risk gone?  Well, if you can count in the ECB to not be idiots, then it is reasonable.

It is like picking up pennies because you are not depending on balance sheets to determine credit risk.  You are depending on an outside buyer to put a bid under government securities that no one would touch otherwise and there an unquantified limit on this.  It gets pretty hot when the bid comes into question b/c some idiot technocrat can't see he is cutting his own balls off.


WhiteNight123129's picture

That reminds me of Paulson supposedly an arb fund who buys whatever hostile deal, up in the air corporate action, and takes leverage on the risk deals he books, introduce some external shock and his strategy blows up. I can see the logic of having a backstop but for how long? Arb is usually good when the shock occurs and no one touches the relationship, I guess when the idea of no trigger on CDS shocked the CDS arb guys, the one on teh sidelines made a killing (being on the sidelines pay-off specially when the other guys are chasing pennies with tons of leverage, they just make themselves vulnerable ot a shock. )

I do not know if ECB are idiots but from an historical standpoint, all currency unions failed except when the resulted in a new country (german principalities currency union ==> Prussia and American Colonies ===> USA with Hamilton, you guys are more versed than I am on that).

So the point is how do factor a chaotic event like Greece gets out in a hard default, run on the Southern European banks, Portugal gets out, spread gets totally out of wack, ISDA suspension of trading for a while? (that would not be unprecedented)

jm's picture

Everybody is picking up pennies even if you hold your money in 3M tbills because unpredictable, adverse things can blow anything up.  It's all relative.  That said, I respect the tail risk guys more than I did earlier this year, but I just don't see how you can make money that way over the long term.  You lose fortunes waiting and you are as often wrong as you are right.  And some guys just seem to have a magical gift to intuit and anticipate like Gundlach and Steinhardt.  Just amazing:  looks like art not science or craft.

I think that mean reversion works best given 3 sigma+ moves.  Moves like that are driven by external shocks-- like Fukushima.  What happens in between those outliers is random drift. Mean reversion happens when people determine it wasn't as bad as they thought it would be.

Regarding the backstops, I'm not necessarily saying how things ought to be, just how they are going to be.  A state can't stand by and see credit markets lock up for long.  The ham-handed way Trichet dealt with the situation (raising rates) and Merkozy inconsistency is just irrational. For a policymaker to ignore the needs of the majority of the EU just because Germans insist on kicking all of the EU including themselves in the balls is stupid. It is even more stupid when Germans insist they are going to get a hand-job even as the boot is about to meet crotch.   

ebworthen's picture



" This trade which buys bonds (optically improving the market's perception of reality)..."

Isn't this the problem with all swaps, and our markets in general?

Markets cease to be markets when speculation and leverage exceed capital formation.

Damned seven-tiered roulette wheel.

Ghordius's picture

"Unlimited" liqudity generates nearly "unlimited" speculation.

Nice, first you set fire to the house, then you sell fire insurance, then you short the insurer, then you buy up the insurer, then you sell water to the fireman, then...

...all thank you for saving your house and your insurance company

jabaykhan's picture

have reuters, not bbg. do they use z-spread in bbg for basis calc?

jm's picture

bbg gives you both z-spread and gross spread in the asset swap calculator. 

electricgorilla's picture

The scary thing for the ECB is when the decompression of the spread between the bonds and cds occur but the basis traders decide that its not worth it to capitalize. The ECB is lucky these traders were even willing to capture spread when Greece was on the brink.

There's a 1,000 pound Gorilla on the back of the ECB with a hundred more 1,000 pounders waiting in line to jump on board

Snakeeyes's picture

Here is my attempt at summarizing the European Debt Crisis in ONE MINUTE!!!!!!!! For presentation tonight at George Mason University.

Economic Minute Presentation on the European Financial Crisis - Low GDP Growth, Staggering Debt, Geithner On The Prowl In Europe!


Peter K's picture

As far as price action in the btp and spg is concerned over the last month or so, it appears to me like the ECB is taking down a lot more paper than is showing up on its books, as reported each Monday. Got a sneeking suspicion that they are parking some of the stuff somewhere, maybe at the EZ CB's (?), or maybe in a FED account (?) at the ECB.

Is it just me(:?

Market Efficiency Romantic's picture

trying to maintain the technocrats' credibility. Unfortunately well advertised, so there is a political arbitrage game playing out. That's so Soros 2.0, speculation against technocrat credibility. Only that in this game, the dealer also sits at the table - with an evil grin on his face.

And the game has long been lost for sovereigns. Allowing technically fester CDS quotes and unregulated player/dealers to determine sovereign debt prices puts sovereigns with >95% of chips on the table in a pretty poor position.

Snakeeyes's picture

For the short run. Here is my presentation tonight pdf that I will also be giving to Congress tomoirrow. NOT testimony, just an information session.

Economic Minute Presentation on the European Financial Crisis - Low GDP Growth, Staggering Debt, Geithner On The Prowl In Europe!