As if there wasn't already enough pressure...

source.markit.com
By Gavin Nolan
Markit Credit Analyst

The state of the sovereign CDS market today could only be described as one of capitulation. Records for spreads have been broken with regularity in recent days but today they were shattered. This was encapsulated by the Markit iTraxx SovX Western Europe index, which widened by 14.5bp to hit 240bp this morning. Less than two weeks ago it was trading at 186bp, a move of more than 50bp. Unsurprisingly, the turmoil in the sovereign market had a direct impact on the broader credit markets, with the Markit iTraxx Europe widening 6bp to 116bp, its widest level since November 2010.

And, of course, spreads in the peripherals continued to widen into unchartered territory. Greece (1,900bp, +174) went even further into the stratosphere, its spreads touching almost 2,000bp. The disunity within the EU corridors of power, as well as the political and social upheaval in Greece, has shaken the markets. Investors have been alarmed that the two factions – Germany and its allies on one side, France and the ECB on the other – have been unable to reconcile their differences. But news emerging this afternoon suggests they will be given more time. The FT reported that the EU had reached a deal with the IMF that will see the disbursement of the next EUR12 billion to Greece without an agreement on a new bailout. Previously the IMF had insisted that a bailout agreement was a necessary condition for its cooperation. The news helped spreads recover some ground in the afternoon.

But the recovery was modest, and a closer look at the reported terms of the deal revealed why. EU Commissioner Olli Rehn made it quite clear that the disbursement would not happen if the Greek parliament did not pass new austerity measures agreed by the government last month. Familiarity with the current Greek political situation will show that this is far from a foregone conclusion. The Greek prime minister George Papandreou is fighting for his political life after he failed to forge a government of national unity yesterday. Several senior members of his cabinet have resigned and Papandreou is now facing a no confidence vote. This political instability is heaping even more pressure on Greece from the capital markets, making further spread volatility all but inevitable.

Portugal (810, +21) and Ireland (805bp, +34), the two countries viewed as the next most vulnerable by the markets, also widened sharply. That is now an established pattern given both sovereigns’ reliance on external agencies for funding. But Spain (300bp, +13) saw its spreads widen to over 300bp for the first time since January this year. The Iberian country is widely perceived to have decoupled from the other peripherals, and its spread performance reflects this. However, the plight of Greece and the panic in the sovereign market has brought the risk of contagion to the fore again. This is the real risk that the market fears, and the Spanish CDS is a good a gauge as any of this fear. Investors know that a Spanish bailout would be of a different order altogether to those that have passed thus far. Weak demand for Spain’s bond auction today suggests that the decoupling theory has its doubters.

The recent volatility in the sovereign market has resulted in liquidity being concentrated in the index, i.e. the Markit SovX WE. Volumes were almost twice the monthly average yesterday and its is likely that they are high today. A large positive skew has opened in recent days, again indicative of participants preferring the liquidity of the index to the patchy single names.