Tuesday, May 24, 2011

Hate Spain? Why buying 5y Germany CDS makes sense

Why going long Germany 5y CDS @ 40bps makes sense:

Considering that the markets aren't as naive as in 2008 (Germany CDS below 10bps) and the recent lows were around 20bps and there are possible catalysts in the upcoming months it seems like a good risk-reward bet. Worst case/stop-loss: 5x20bps = -100bps ([20out-40in] * 5y duration) in a sweet spot scenario.

Now consider that the recent highs, where stress and volatility we in vogue, were around 60bps.. that's a 1:1 bet.
But the convexity is on your side on this trade. If things turn out to be worse than expected. If there is a restructuring. If global economic activity slows down. Etc. Out of question, but odds are higher than what the market is pricing.

Why this bet?

These guys aren't doing so well. They sure look like they're improving, but we cannot forget that their growth isn't sufficient to bring Debt/GDP down.

Current yields on short-term debt (easier to find buyers), close to near-term highs.
3m Bill @ 1.43%
1y Bill @ 1.95%
1.5y Bill @ 2.25%
2y Bill @ 3.69%

Unemployment rate above 20%, still not quite declining, but stabilizing at an elevated level.
Industrial production still close to the lows.
Retail Sales making new lows.
The Housing industry is still very, very bad and it was a great source of revenue for the local governments.Now a big source of mortgage problems.
Trade Balance is still looking pretty bad.
Current Account, you all know the story.

I am really not sure what will be able to pull Spain out of its current orbit.
Without a sovereign currency to devalue... The current pile of debt, even though relative-to-GDP small compared to Greece, Ireland, Italy, Japan, will not go down any time soon. That is my belief.

Fiscal deficits + higher yields on debt than the country's growth rate + negative current account and trade balance + high structural unemployment + can't devalue its way out.

The bet doesn't seem too bad for a horizon of 3-6m. If nothing happens that's 10-20bps in costs (90/360 * 40bp to 180/360*40bp). 
Cheaper than a 10% OTM S&P Index Put for the same time horizon (3.8months, ESU1P 1200 @ 20pts = 1.5%, 8x more costly).

The debt load on Spain is huge and it is piled onto balance sheets all over Europe.
What if the guys who won elections this Sunday find those talked-about local hidden bills and make it public?
A. Lost confidence will spook investors.
B. The aggregate debt to GDP number will look even worse.
C. Trichet could (I don't think he will) hike rates by more than 25bps in 2011, making things even worse for liquidity and opportunity cost "Why buy Spain 3m bill @ 1.43% if Germany is @ 0.89%"?
D. Housing still deteriorating will put more pressure on balance sheets: household and corporate/financials.
E. Activity will stall.

Yes... perhaps european banks, the DAX, the IBEX or the EUR will suffer much more, much faster and the volatility on the puts would explode, but I still like the trade due to its lower volatility in carry and much longer time horizon to get things right.

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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