Robert Kitchin, Head Of Credit, Comments: Sovereigns Reign - International Finance Review

The past nine months have been like no other period in the sovereign CDS market. Average ticket sizes have not increased, but the breadth of accounts in and tracking the market is up substantially. The focus on sovereign CDS is expected to intensify yet further as signs emerge that the recovery story that has lifted all asset classes may be losing some momentum. Jean Haggerty reports.

The past five trading sessions have offered an indication that the rally in risk assets may be fading. Against this backdrop, some market participants are re-evaluating the recovery story that has shaped sovereign credit default swap trading activity during the past quarter and re-assessing their expectations of the state of G10 economies over the next one to two years.

With a view to protecting pre-summer gains and on expectations of a gradual widening of sovereign credit spreads in the coming months, some long-only real money accounts have been taking off sovereign risk exposure in recent weeks.

"We have seen spreads widen out and then tighten again, and now it would seem we have entered a period of being relatively directionless," said Rob Kitchin, head of credit at BGC in London.

Much of the sovereign CDS trading that is occurring now is centred on seeking out relative value opportunities between sovereigns and banks and between sovereigns that have similar debt profiles.

Central bank action, which passed a great deal of financial strain on to sovereigns, appears to have helped avert a catastrophic depression. Also, according to several reliable measures, stability has returned to the market and sovereign credit spreads have stabilised.

Increasingly, some market participants are wondering if the "green shoots" that they have been reading and talking about are real or if they are fading.

"The fear of increased systemic uncertainty in the markets earlier this year has certainly reduced, and as such, spreads have tightened and curves dis-inverted heavily. [But] recent concerns about the ability to fund stimulus packages, as highlighted by moves in the interest rate markets, have reignited the discussion about sovereign solvency once more and the credit derivative market is starting to reflect this concern," said David Cross, JP Morgan's head of sovereign derivative trading for Europe.

Breadth breeds stability
Sovereign spreads rallied so sharply off their widest levels, seen in late February, that there was bound to be a period of consolidation, noted Zoeb Sachee, head of interest rate derivatives trading at Citigroup in London.

"I suspect the recent widening is being driven largely by technicals and profit-taking rather than a return to risk aversion, and that we have seen the widest levels of this cycle," he added.

In general, a return to the state of panic experienced during the first quarter is not expected, and to some degree the noteworthy increase in the number of accounts trading sovereign CDS is a factor.

According to some dealers, the jump in CDS volumes since the sovereign CDS market stirred to life in late 2007 is partly attributable to the breadth of new users of the instrument. Whereas other OTC derivatives marketplaces have been witnessing volume contraction due to hedge fund closures and pull back, sovereign CDS has attracted greater participation.

For event-driven hedge funds and hedge fund managers previously engaged in foreign exchange, interest rate, equity and in other credit markets, sovereign CDS has come into their consciousness during the past year.

Early warning
The number of non-traditional market constituents seeking access to sovereign CDS data when examining default risk on sovereigns, such as that on Ireland, has grown considerably over the past year.

According to Sebastian Meyer, senior data analyst at CMA DataVision in London, the number of foreign exchange traders, governments, quasi-government agencies and corporates that have contacted his firm looking for access to CDS data to inform their investment decisions has grown considerably. This interest is not necessarily a precursor to trading activity, however.

During this crisis, CDS has provided a reliable indicator for the sovereign market. For example, five-year CDS referencing Ireland reached a peak of 400bp at the end of February, but it was only downgraded weeks later (see Related Information "Sovereign CDS: the impact of FIG and downgrades").

Also, during all of 2007 and 2008, CDS on Iceland traded wider than all other Western European countries and throughout this period Iceland CDS was correlated strongly with Landsbanki Islands, Glitnir Banki and Kaupthing Banki, the three Icelandic banks that defaulted last autumn.

"The moral to take out of that was that even if you are not actively trading in the sovereign CDS market, you should be looking at the data," Meyer said.

Heading into this summer, Latvia and Hungary and the nations whose banking sector is most exposed to these and other Baltic states at risk of experiencing currency devaluation are being tracked closely.

Sovereign risk on Germany and the UK is also undergoing greater scrutiny as both countries face elections during the next year. So far, the market has reacted positively to the firm and fast policy action taken by governments to avert further systemic issues.

"Focus is increasingly shifting to the action that needs to be taken by governments to manage their way out of this increasing debt profile," Cross said.
 

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