EURO CDS Chart Update

by: Acting Man

Below is an update of the latest CDS charts on euro-land sovereigns – as can be seen, the recent differentiation between the smaller and bigger countries in the PIIGS stable continues and even Ireland's spreads are now coming in sharply following the bank stress test.

Similarly, CDS on Middle Eastern sovereign debt continue to decline, in spite of unrest in Yemen and Syria.

The "Spain is not Portugal" chorus is alive and well and it must be noted that it is for now on solid ground, at least in terms of market perceptions. CDS on Spain's sovereign debt continue to retreat and Spain has seen a small decline in its bond yields as well, which are essentially moving sideways in recent months, with slight downside bias. A recent WSJ article notes that bond markets are indeed suggesting that Spain is different – at least over recent months and weeks.

(Click to enlarge) 10 year bond yields compared, Spain vs. Portugal

As we have noted previously, much will depend on how the euro area and the world at large fare economically over the next several months. A continuation of the boom in Germany will give the euro area periphery much needed breathing room. On the other hand, the longer the global economy is seemingly withstanding the recent moves to tighten monetary policy in numerous countries, the more likely it is that commodity prices will continue to surge. The effect of the sharp rise in energy, metals and food prices has not yet fully percolated through the economies that are their biggest consumers, but it undoubtedly will. As long as central banks are accommodating the rise in raw materials prices by expanding the money supply, demand will hold up, but to the extent that such accommodation in terms of monetary pumping is taken back, the price rises will impact negatively on both consumer spending and corporate profit margin.

Our friend Dr. Jim Walker at Asianomics calls this the global consumption tax or GCT for short. Naturally, the incomes of commodity producers are raised to the extent that commodity consumers suffer, but this is not a shift in wealth that can be regarded as non-disruptive or economically neutral. To the extent that commodity and other higher order goods prices are rising relative to the prices of consumer goods due to loose monetary policies, these changes in relative prices are going to distort the economy's productive structure. As we have noted in the past, even if one looks at just the U.S., one can see from the ratio of spending on business equipment production to spending on non-durable consumer goods production that a massive shift of resources to the higher order stages is underway ever since the Fed's extremely loose monetary policy has begun.

Such artificial booms are by definition not sustainable. By constantly interfering with the reordering of the capital structure and the liquidation of unsound investments and the unsound credit supporting them, governments can create short term feel-good conditions, but only at the price of an even bigger downturn at a later stage. Unless the economy is allowed to reestablish a sustainable production-consumption balance, we will just lurch from one boom-bust cycle to the next, consuming ever more scarce capital in the process.

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The ratio of business equipment to non-durable consumer goods production – a rough indication that factors of production are increasingly drawn to higher order goods production. This would be fine if it were a result of a rise in voluntary savings, but interest rates have been manipulated lower by the Fed, and the money supply TMS-2 has expanded by nearly 33% since August of 2008. Note that the ratio is far away from its historical average.

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A long term chart of the same ratio shows how far removed from its pre-bubble average it is nowadays.

For a country like Spain, the consumption tax aspect of rising raw materials prices outweighs the rise in incomes of commodity producers by a large margin. Hence the recent relative calm in Spain's bond market may prove to be the eye of the storm, especially if the ECB and other central banks get worried enough about rising commodity prices that they keep raising rates. Another point that worries us about Spain is that there could be a strong political backlash to the government's austerity program. Already prime minister Zapatero has made it known that he won't run in the next election, no doubt because he fears just such a backlash.

We suspect it won't take much to unsettle the bond market again, so we believe one would be well advised to hope for the best and prepare for the worst.

On to the charts:

1. CDS (prices in basis points, color coded)

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5 year CDS spreads on Portugal, Italy, Greece and Spain – the gap between the bigger and smaller countries continues to widen.

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5 year CDS spreads on Ireland, the senior debt of Bank of Ireland, France and Japan. Irish CDS retreating strongly in the wake of the latest bank stress tests and growing confidence that no haircuts will be demanded from bank bondholders.

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5 year CDS spreads on Austria, Belgium, Hungary and Romania – all still declining of late.

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The Markit SovX index of CDS on 19 Western European sovereigns – remains in a mild downtrend, testing lateral support.

2. Euro Basis Swaps and Other Charts (prices in basis points)

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One year euro basis swap – continues to improve, indicating there are no worries about euro dollar liquidity at the moment.

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5 year euro basis swap – a similar picture.

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5 year CDS spreads on Australia's Big Four banks – once again retreating, which indicates that there are not yet any funding problems on the horizon (the big four get most of their wholesale funding from overseas sources). Note though that lately, subtle cracks have begun to become visible in Australia's housing boom nonetheless. We will continue to keep an eye on developments there.

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5 year CDS on Saudi Arabia, Bahrain, Qatar and Morocco – all remain in their recent downtrend for now.

Charts by: Bloomberg, JP Morgan, St. Louis Federal Reserve Research.