Friday, May 28, 2010

Cannot Get Eyes Off The Spanish Sovereign Spread

Despite the rally in risk assets in the last couple of days, and the QE by ECB ... my eyes "watch the strength" of Spanish sovereign spread. Click on chart below, Spanish 5 year benchmark bond over Germany, data courtesy of Reuters.

Jim Reid, the strategist at Deutsche Bank, explains today:

... but if we only had to look at one thing we'd probably keep it simple and look at peripheral Sovereign spreads. The reason for this is that this is the market we have to stabilise before we can put this stage of what will be an ongoing crisis to bed.

It must be disappointing to both the market and the authorities that 5yr peripheral CDS spreads for example are now pretty much at identical levels to where they were around the time of the Trillion Dollar bail-out package 3 weeks ago. One could actually be concerned that Spain and Italy are around 30-40bps wider than where they were on the Monday morning immediately following the bail-out. So a Trillion Dollar commitment plus ECB buying has yet to make a lasting impact on the epicentre of this crisis. We think it eventually will as the political commitment is extraordinary. However until we see clear signs that the free market wants to buy peripheral debt then the risk is that the package and the European resolve is tested one more time. This would likely bring a fresh bout of market volatility.

Our interpretation of current events is that they are similar to those seen in the corporate credit market back in Autumn 2008. Back then corporate credit became absurdly cheap due to the dramatic collapse of leveraged positions (SIVs being a huge factor). However the market needed several months of these very wide spreads to locate new unlevered buyers to replace the old leveraged buyers. Peripheral Debt today is similar. We need to find investors to take place of those Government bond investors who have now decided that their job is to take interest rate risk and not credit risk. So unless the free market makes this transition quickly, the authorities may soon be forced into more aggressive action. So for us Sovereign spreads are still at the epicentre. Everything else is highly dependant and will respond to this.

Going to search for investors ...

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