The Sovereign Risk Dislocation Trade Means Big, Black Clouds Coming To "Risk Free"

As early as July, we pointed out the increasingly likely endgame in Europe with regard to the EFSF and centralizing/concentrating credit risk. Well sure enough, sovereign risk has risen dramatically for Germany (among many others obviously) as traders realized standing on the shoulders of giants does nothing but push them further into the dirt. What is becoming more worrisome, and dramatically escalating, is the rise in sovereign CDS relative to government bond yields - or the so-called 'basis' - as it becomes ever more clear that government-bond-yield-by-mandate may not be as 'real' a measure of the risk-free rate as CDS.

Sovereign CDS are denominated in non-local currency - i.e. the spread not only accounts for the chance of technical default but also of a hyperinflationary revaluation of the currency. It is this fact that could make them a far more accurate indication of the real risk in government bond markets - far more so than government bond yields themselves as they remain largely under government or central bank mandate wherever we look.

Charts: Bloomberg

This week saw German CDS pass Bund yields for the first time ever in the 5Y maturity. The 1 week change was over 3 standard deviations - the largest ever! Also notice the Swiss basis jumped when they announced their EUR-peg / implict devaluation 'effort' and how it has pulled back more in line with Germany in the last week or so.

What is notable from the upper chart is the close relationship between US, UK, and German 'CDS - Government Bond Yield' 'Basis'. It seems interestingly coincidental that their bases has tracked each other so closely over the last few years as their government bond yields have varied so differently.

Japan is clearly the most worrisome as CDS appears to price for significantly higher chance of default (or by implication devaluation of the JPY).

China is now starting to catch up the rest of the world after breaking away from it during QE2. China's overnight move in sovereign protection was extreme to say the least - last night's move was well over 3 standard deviations for the CDS alone and the basis jumped dramatically - perhaps the trade of the year will be a China Sovereign basis trade?

The bottom line is that CDS markets potentially offer more insight into the market's perception of 'risk-free' government bond risk (yes we see the irony) as it implicitly reflects both default risk and currency devaluation risk (or in extreme hyperinflation). In an era where governments and central banks spend all day buying back their own debt or managing their own maturity schedule/funding with fiat currency, perhaps following the CDS market is a cleaner way of thinking about 'risk-free' and the basis provides clarity on how much that 'risk-free-ness' is changing.