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?
1) Domestic Bank holdings of Spanish bonds have surged... and dealers tied by Basel III RWAs will not inventory positions - leaving only fast money pinging risk around and self-referential domestic banks more than willing to load their boat with ECB collateral in a circular reach-around of glory (see CNBC ebulience every time an auction goes off!!)... once the fast-money leaves the building, and risk flares - who will save the precious domestic bank capital then? CDS traders? hhm, no...
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2) Sovereign CDS markets no longer useful signals and arbitrage means technical drag on bond spreads... CDS (green) and bond spreads (orange) have tracked relatively well - but since the beginning of the CDS ban discussions, traders have reduced exposure en masse (enough to practically kill even the SovX index) leaving the basis between bonds and CDS wide enough to drive a truck through BUT noone willing to since proving the correlation required to hold sovereign CDS is too onerous (and as we warned here [10], there are unintended consequences). Managers are loathed to take on the SGB risk (as seen in point1 - leaving only the domestic banks to soak up their self-satisfying sovereign risk)... And withbasis traders gone from the equation, should we see a risk flare, there will be no-one to soak up the illiquidty premium in bonds (unintended consequence!)
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[as a side note - one does have to wonder whether the compression in Spanish CDS is led by a swathe of self-referential CDS protection writing by Spanish banks? Its not quite as ridiculous as self-referential name CDS - but still thanks to LTRO, the banks and the sovereign are as agood as one and the same]
3) The strength in Spanish bonds is driven by compression in the front-end by 'hope's of OMT - which is conditioned on Rayoy's Request for aid. The lower spreads go - the less likely the Spanish are to ask for aid - given the conditionality - and the implied support becomes worth-less. What is fascinating is the outperformance of UK-Law bonds over local-Law bonds remains a huge margin - suggesting (rightly so) that hedge funds and fiduciaries are willing to pay up for legal protection over the inevitable subordination (no matter how many times we are told pari passu). The following chart shows the outperformance (A EUR6 compression from the EUR14 differential when we suggested the trade - quite an impressive unlevered return even if we say so ourselves) as the UK-law bond is up 10.6% (middle pane) and the local-law bond is up only 1.95% (lower pane)... Event Risk concerns remain high...
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4) We've seen this pattern before...100%-plus up in risk, 35%-plus retracement, and repeat...
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But apart from that (oh and record high and escalating Spanish bad loans and a 'bad bank' that will not be taking on RMBS), Spain is all good?