Why Euro Core CDS Spreads Are Rising, Even As Bond Yields Fall


[credit provider=”Markit via FT Alphaville” url=”http://ftalphaville.ft.com/blog/2011/08/11/650846/a-cds-basis-pain-trade/”]

CDS spreads are at record levels and rumours of bans on short selling abound, but yields on Italian and Spanish bonds are still falling after a brief turnaround yesterday.FT Alphaville’s Joseph Cotterill explains what’s going on:

Again, Italian and Spanish bond yields are falling, but the CDS continues to blow out. An interesting move and you may think it’s an indictment of the ECB’s bid to stifle sovereign volatility with its buying. You could also take it as a sign that markets are pressing French and German credit as underpinnings of the euro…It’s febrility feeding febrility.

But CDS sellers know better than to insure debt they can’t cover — and everyone understands the amount of sovereign risk in European markets right now — so they’re not selling. That’s why this isn’t your typical, runaway CDS issuing moment.

“In the grand scheme of things, the blow-up of this trade doesn’t amount to very much at the systemic level, both in terms of the exposure outstanding and the dynamics of the trading. (It’s the opposite of the usual regulator fears over CDS systemic risk, i.e. that morons are writing CDS protection that they can’t back with cash. Not the case, and not implied by net notional.)”

He has more to say about basis trading — and why it won’t work — in his at FT Alphaville.