Tuesday, April 10, 2012

Spain's spreads breaking away from other risk indicators

As the sell-off in Spanish government bonds continued today, Spain's spreads broke away from other global macro risk indicators. Typically Spain's bond and CDS spreads move in tandem with risk measures such as VIX or SovX WE (MarkIT Western European index of sovereign CDS), etc. But this time around, the widening has outpaced these other measures. As an example consider the relationship between Spain's 10yr bond spread (to Germany) and SovX WE (chart below). The red asterisk indicates the current levels.

Spain to Germany 10y Gov. spread vs. SovX WE spread (last 2 years; source: Bloomberg)

One can run the same comparison against VIX or swap spreads and get a similar result. Using Spain's CDS spreads rather than bond spreads also shows that we are in an uncharted territory with respect to this widening. Consider for example that the last time Spain's 10-year spread was at current levels (4.3%), VIX was around 30 (it's 21 today) and the USD 2-year swap spread was over 50bp (31bp today) - see chart below.

Spain to Germany 10y Gov. spread vs. USD 2 year swap spread

Clearly there is plenty of room for the other risk indicators to "catch up" with Spain. But for now it stands on its own with respect to the relative amount of risk that is being priced in. More Spanish and Italian debt auctions loom and it is uncertain just how much more room the periphery banks still have to absorb the extra debt. In the mean time foreigners continue to sell.
Reuters: Spain has found itself the focal point of those concerns after relaxing budget targets earlier this year and with subsequent budget-cutting plans winning little investor support - culminating in weak demand at an auction last week.

Spanish 10-year yields jumped 22 bps on the day to a four-month high of 5.99 percent before finding resistance at the psychological 6 percent barrier - though few in the market believed that level would halt the selling.

"We're going to see Spain develop as the story this week as hedge funds look to short it," a London-based trader at an investment bank said.

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