A Strange Graph – In More Ways Than One

First, the graph is strange because I had a lot of trouble formatting it.  My apologies.  But there is a reason I have sent it.

The “dotted” lines represent the Italian government curves back in November.  The “solid” lines are the shape of the curve today.  The “orange” lines are the bond yields in bps, and the “yellow” lines are the CDS spreads in bps.

Back in late November (pre LTRO and more SMP), the CDS spread was lower than the bond yield across the board (we could look at Italian bond spread to German bunds, or Italy CDS spread to  German CDS).  We have seen a very big move in bond yields.  Yields have moved lower across the board, with the front end outperforming.  CDS has moved tighter, but not by as much, and the curve when from slightly inverted, to slightly steep.

In fact, CDS spreads are now higher than bond yields (significantly so) in the 1 to 3 year range.

It would tell me that the less manipulated market, less subject to non mark to market accounting, has been less convinced by the move.  I would hate to say “smart” money vs “dumb” money, but a bigger % of investors in the bond market are not subject to mark to market and are not subject to being right in the short-term (or with all the bailouts – being right at all).  We have also seen evidence in Greece, that the ECB’s SMP program likes the short end more than the long end, creating another artificial buyer, and they are DEFINITELY senior.  So maybe CDS with less manipulation is a better assessment of risk.  Since that tends to be fast money and mark to market money, it is interesting to see how much above bond yields they are willing to pay (though liquidity is low in sovereign CDS too).  Maybe the CDS market is already pricing in the subordination that will occur if there is another crisis.  The bond market can’t help but be pulled to the level of the ECB bid (though SMP has been quiet for 3 weeks), whereas CDS can anticipate the impact of subordination if things get bad again?

I’m not really sure what the answer is, but think this is worth watching (though in this market, the ECB will now finally get permission to sell CDS, or ban it, because who wants anything out there not fully controlled by the central banks).

Source: Bloomberg