Eric Burroughs's Profile
The curiosities of euro zone CDS and pricing insolvency
One of the most striking aspects of the whole euro zone crisis has been the slow process by which credit and interest rate pricing converged. Say what? In short, in the early 2010 days of the crisis the CDS market began pricing government bonds as credit risk in a way the individual government bond markets were slow to recognize and appreciate. The real flare-up in the crisis happened when those two risks — credit and interest rate — converged. Since the May bailout for Greece, CDS and peripheral yield spreads have mostly tracked each other, especially since Germany’s unilateral short selling ban on sovereign CDS/bonds caused a mini freak-out. Now, it’s getting messy and curious.
Exhibit 1 is the difference between Spanish sovereign CDS and Spanish/German five-year yield spreads, otherwise known as the credit basis. There shouldn’t be a big difference in these spreads because they ultimately gauge credit risk, just in different markets. Until the euro zone crisis really flared up last year, CDS spreads were leading. But all of a sudden, yield spreads are the ones leaping higher even as the most liquid five-year CDS spread stays below record peaks. Does that mean cash bonds are taking the driver’s seat in this move?
Not necessarily. Just look at the latest crisis target, Belgium. It’s not exactly news that Belgium is on the verge of splintering and no longer existing, potentially turning the heart of the European super-sovereign — Brussels – into a city-state. But that seemed to be enough to prompt a full attack by hedge funds knowing the blood in the water and seeking to exploit the coutry’s and region’s problems. But the 65 basis point spread difference between the CDS spread and the government bond yield spread seems a bit excessive. If anything, it shows the CDS hedgers/specualtors are being more aggressive with Belgium than they are with Spain — a bigger target who has secured some backing from China. And it just goes to show that both cash bond spread moves should be taken with a certain grain of salt, as should the CDS moves.
Then there is Ireland. In the past week the CDS curve has inverted anew, suggesting that investors see a greater risk of default in the next one to three years despite the bailout that last November (the chart below shows the Irish one-year CDS spread in blue, five-year spread in maroon and net notional volume written on Irish sovereign CDS in orange). Europe is clearly struggling to contain these latest troubles. The market pricing suggests, as one macro hedge fund manager recently said, that liquidity is at a premium no matter the market. Plus with the European Central Bank spreading its intervention, it’s getting even tougher to price euro zone credit risk as the bond buying spreads from country to country. One reason why Spain and Belgium are seen as more pure proxies at the moment is because the ECB has not yet spread its intervention into those bonds. Yet even with the ECB intervention, both Greek and Irish one-year CDS spreads have edged above benchmark five-year spreads, though the widest spread on the curve remains the three-year. So the market is pricing in a greater risk of default on a one-year horizon than a five-year horizon (inverted credit curve), with the greatest risk at the three-year horizon, roughly matching the 2013 EFSM EFSF expiry. That just goes to show the rising expectations that a debt restructuring of some kind may be in store for banks and debt investors, and if not that a default is becoming more probable in the short-term. Keep in mind the European Commission pretty much exonerated the sovereign CDS market of being the main drivers of the crisis.
This is a classic case of contagion very similar to the financial crisis when Bear Stearns first came under attack, then Citigroup, Lehman Brothers and the banks seen in a weaker condition. The pressure will persist until Europe comes up with more radical solutions. Despite the attempt to shock and awe with the EFSM and EFSF (interesting report to the European Parliament calling the programs legally shaky and saying it’s questionable they can retain AAA ratings), the problem is that an increasing number of these countries are seen as insolvent. It’s unclear how much money and future nominal economic growth will be needed to make debt financing more sustainable, and how much Germany and/or other countries are able or willing to pony up. Domestic politics has yet to throw a serious monkey wrench in the works — yet.
Stephen Jen, managing director of macroeconomics and currencies at hedge fund BlueGold Capital, nicely summed it up this way in a note to clients this week:
“The policy responses in Europe in the past year have been cancerous in that, in contrast to how banking crises are usually dealt with – good banks are consciously separated out from bad banks, through the various bailout programs in Europe, the bad government balance sheets are effectively merged with the good government balance sheets. Such a process is deemed necessary by Eurocrats, in the name of ‘saving the euro’. However, this unlimited willingness to support the weak partners is not commensurate with the limited capacity for bailouts. We believe Greece, Ireland, and Portugal are likely to be insolvent. As their costs of borrowing continue to diverge from their nominal GDP growth rates (r > g), investors will be increasingly worried about their solvency. In turn, the AAA-rated EMU countries will be under more pressure to finance more bailouts. The key threshold of this collective capacity for more bailouts is the AAA ratings of Germany, France, the Netherlands, Finland, and Austria. ”