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Market Weekly

Monday April 30th 2012

images/uploads/SPL Market Weekly 30-04-12.pdf

From Market Weekly...

Portugual...An Unexploded Bomb
The deviation to a wider level in sovereign CDS over the week is hardly noteworthy. What is impressive is the way Portuguese paper has moved tighter -113bps on the week. The spread of the 10 year PGB (should be called UXB) over Germany has proven extraordinary as it stood at +1174bps on December 30th, rose to +1333bps on February 3rd and yet at the close of last week was down to just +897bps.
Portugal has benefitted on one score, simply because it is not Spain…i.e. the larger Iberian nation has pushed Portugal out of the limelight…in the way that France, post May 6th will Spain.
However, we worry that the market has become too complacent about Portuguese risk in that:
We believe that in February the ECB was active and it set a tone for the notable compression of yield and spread. Widen this play out to the CDS space and the drop in the basis between CDS and bonds for Portugal which was extremely wide for an illiquid  bond and CDS market and we suspect it was just too tempting for hedge funds not to buy exposure as a package.  
Since February 3rd they bought bonds and also acquired CDS protection to lock-in the spread between the two assets. That demand for the basis has pushed it to near 8 month lows.
Why are we worried?
This trade is “theoretically” risk-free spread carry…but given our key point marked in red above we now see this actually developing a malignant risk premia.
An event will trigger CDS…longs beware!
Similarly... we have noted that the Spanish 10 year paper keeps bouncing back from 6%. We suspect that so far just spanish banks and indeed the CB have been soaking up positions. However, we may just be at the point where a new trade of going long Spain between 5,95% and 6.00% and also being long the CDS at 475bps to 500bps is going to replace the Portuguese position.
Too often we think in a form of "Monochrome", i.e. "Good or Bad"..."Black or White"...the opponents of the free financial market often are quick to hurl rocks at the financial systemn and the derivative products. This is a situation where judicious use of a "LONG" strategy in both debt and CDS may well allow destressed sovereigns to feed off lower yilds for longer than would ordinarily be the case.
BUT....and this is key...these trade windows are not open for ever...once exhausted they will atat to close and the stampede for the exit door can trigger an almighty collapse in bond prices and an Apollo Saturn V surge in yields.

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