Whether the market is expecting more significant deterioration with the European debacle or somewhat perversely a rapid-response by the ECB (with its flood of EUR overwhelming USD), it appears the USD-denominated Germany CDS spreads are once again pricing in notable devaluation in the EURUSD exchange rate. Given the US and (almost explicitly given its dominance) Germany are more currency issuer than user, default risk is not the main driver of the CDS spread but currency devaluation (some might call it inflation) is much more of a factor. After EURUSD and German CDS being tightly coupled for months, last summer-to-fall's Eurocalypse disconnected them as the CDS market led exchange-rate lower. It seems with the current dislocation that USD-denominated (and EUR paying) German CDS are expecting EURUSD at around 1.1750 - or a 6% devaluation of the EUR. With today's dismal confidence data seeming enough bad data to spark QE3 hopes over here, we can only imagine the relative size of print-fest the two central banks will need to create in order for CDS to be correct.
The post LTRO2 few weeks seemed to bring CDS and FX rates back into a calm place together (similar to the first half of 2011) but the escalation of Greece (elections) and Spain (banking reality) seems to have forced CDS to price in more devaluation (printing) risk once again...
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An alternative perspective is that of Germany's real risk of being overwhelmed by its TARGET2 demands and real default risk rising for the heart of Europe as it bears the load.
Chart: Bloomberg