German sovereign CDS widening is a troubling sign
By Sober Look
The focus recently has all been on the Eurozone periphery, but signs of strained financial conditions are now showing up in German sovereign CDS. The spread has been steadily rising (as discussed here).
CDS spread (bp)
This CDS widening has been taking place at the time when German bond yields have been falling.
This divergence (bond/CDS basis) indicates that bond prices are driven by demand for "safe" paper in the euro area while German sovereign risks, visible in the CDS markets, are perceived to be increasing. Somewhat of a contradiction. But these have become common in the stressed environment we are in. One could presumably lock in this difference by shorting the 5-year government bond (by borrowing it in the repo market) and by selling the 5-year CDS against it. Assuming this position is held for 5 years, the trade will work. However until then the spread could widen even further if for example the 5-year yield goes to zero and/or the CDS widens. The mark to market volatility of this position could be substantial and the return on capital wouldn’t be great because of the margin required (initial and variation) for shorting the CDS. That’s why market participants are not all jumping into this "arbitrage" situation (also if the German CDS were about to trigger, there may not be a DC [ISDA committee] around to trigger it – but that’s a topic for another discussion.)
To an economist this raises all sorts of questions such as what is the "risk-free rate" for the euro. And how can German paper be viewed as risk-free when German sovereign CDS is wider than Verizon, IBM, Pfizer, Microsoft, etc. CDS? What this tells us is that investors are becoming concerned about Germany’s growing liabilities associated with the Eurozone. And this concern stems from the fact that the costs to Germany of a potential breakup of the EMU would dwarf the costs of German reunification, which took the country a generation to absorb.