Visualizing The Death Of The European Sovereign Credit Market

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.

Equal- and GDP-weighted European Sovereign CDS spreads have collapsed as the market has died.

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.

Clearly, the tight relationship between CDS and bonds has broken - as CDS risk has collapsed, bonds did not follow...

We have noted many times before that sovereign CDS are nothing less than a cleaner signal than bonds (both credit and redenomination risks) and as has become very clear, the reality was far worse than even CDS had suggested - when noone believed Europe was in trouble. The problem with the CDS ban (which is implictly what has occured given the inaneness of the correlated hedge model required to prove un-nakedness) is it has notably unintended consequences.

Bonds have rallied but this is more consequence of front-running Draghi's OMT than CDS compression.

For Spain specifically, bond spreads are merely back to six month lows while CDS have collapsed to 18-month lows - massivley dislocated. Typically this would bring huge basis trade flows to notch bonds lower in risk (higher in price) but it hasn't!

[This wouldn't be the only unintended consequence of government/central banker action - as the risk-on/risk-off nature of markets has compressed the need to hedge idiosyncratic risk in single-name CDS (as we noted here).]

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.

We are already seeing the front-running effects of Draghi's OMT wearing off on bonds (Spanish bond spreads are over 50bps wider in the last 10 days) and with domestic banks the bulk of the holders (as we noted here), they will be left with a much more noisy balance sheet with no market to hedge their positions in.

 

But apart from that - great job regulators! Just like LTRO, the actions of a politically motivated group of elites has reduced any signaling from the market and concentrated risk in an ever smaller and more dangerous group of entities.

 

The only sizable real money in European sovereign bond markets is domestic banks - all trading flow is now fast money funds looking to pre-position for central bank actions and then sell back into them. This is the death of sovereign credit markets - as while on the surface all appears to be fine, in fact the self-referential nature of the domestic banks gorging (by necessity) on their nation's bonds is creating huge potential for event risk (as is so obviously priced in given the non-local bonds outperformance this year).