In a note, RBS Analyst Chaytor focuses the sovereign CDS market and whether investors should be freaked out about rising spreads.
RBS: Always a dangerous question to answer so early in January, but the early signs are that sovereign risks are key. It is with extreme interest that I note that the iTraxx Western European Sovereign index is trading wide of both iTraxx Main and iTraxx Senior Financials. Ignoring the potential internal consistency in this (especially the latter) for another day it tells us that we (the market) have some real concerns about quite a lot of the sovereigns out there. This presumably stems from the difficult deficit positions that many countries have necessarily found themselves in following the measures taken to stem 2008’s economic catastrophe.
So, how worried should we be about this? At this stage, not a lot I think. The sovereign CDS market is a useful addition to the markets toolkit but it remains a small and illiquid market in relation to the key one – the bond market. CDS vigilantes are a growing and important force, but are as nothing compared to the potential return of the bond vigilantes. What we have to be focused on is whether these latter return. Not just because of the obvious impact it would have on government bond markets but the impact on all other markets. Whether you believe the risk rally is built on excessive liquidity or on the market pricing a return to decent growth rates, a higher cost of money would act to kill that off very swiftly.
So, the Q1 key theme is, I think, whether moves in the sovereign CDS world start to manifest themselves in the broader bond markets. We have seen this already in Greece, but it’s whether it hits the big economies such as the US, UK, Japan or Germany that is crucial. My central scenario is that it will not. That is why I am happy to be tactically long 10y Treasuries through this week’s supply as I said yesterday, a trade which is working and I would stick to. But let us keep a very close eye on key levels in government bond markets over the next few months; as if yields start to rise they could go a very, very long way. Being nimble is vital; luckily the government bond market is liquid enough to allow that.
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See Also:
- Soros: The CDS Market Is Just Legalized Homicide
- CDS Volumes Spike As Traders Bet The U.S And U.K. Will Default
- Buy CDS From An Insurer That Wasn’t AIG? You Got 13 Cents On The Dollar
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