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

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.