I have heard many anecdotes that trading in Western Sovereign CDS has exploded over the past few weeks as Macro hedge funds have jumped onto these trades, which are effectively like a synthetic run on a currency (if these countries had their own currency, that is). It reminds me a lot of the moves in Bank/Broker CDS in March 2008 as hedge funds forced a run on Bear Stearns, and immediately after began to target other banks (e.g Lehman, Merrill etc) after the bondholders were protected but equity holders were effectively wiped out. Government actions effectively provided hedge funds with a precedent, so they jumped onto the next victims.
I bring this up, because I think it is increasingly likely that Ireland will be bailed out, one way or another, in the very near future (possibly as early as this weekend) - even though the Sovereign CDS market is extremely illiquid and probably not a "real" gauge of the market's view of peripheral countries' strength, it is creating such a perception - amplified by media reporting - and has also translated into wider government bond spreads in the cash market. Such actions can demonstrably change the behaviour of both individuals and the market as a whole, forcing the issue and demanding a policy response. I believe that we have reached such a point that action needs to be taken, and Steinbreuck's comments suggest that EU policymakers agree.
Such action is likely to be merely symbolic, at least initially, perhaps involving the Bundesbank being directed to purchase a token amount of Irish Government Bonds in the open market. The problem with this - as seen with the Fed's purchases of MBS - is that to be credible, "significant" amounts of bonds needs to be purchased. However, with the Germans implicitly backing Irish sovereign debt, it is likely that there will be a rush for the door in the CDS market (similar to that in the aftermath of the sale of Bear Stearns). But with a precedent set that Germany will bail-out peripheral EMU nations, the market will begin to gun for other countries, likely targeting Spain, Austria, Italy et al. The obvious question is "where does it end?". There are German elections this year, and given the hardened public opposition to even domestic bail-outs or fiscal stimulus, it seems extremely unlikely that such a move (or succession, thereof) would be tolerated, and inevitable that this becomes a serious political issue.
Such action is likely to be merely symbolic, at least initially, perhaps involving the Bundesbank being directed to purchase a token amount of Irish Government Bonds in the open market. The problem with this - as seen with the Fed's purchases of MBS - is that to be credible, "significant" amounts of bonds needs to be purchased. However, with the Germans implicitly backing Irish sovereign debt, it is likely that there will be a rush for the door in the CDS market (similar to that in the aftermath of the sale of Bear Stearns). But with a precedent set that Germany will bail-out peripheral EMU nations, the market will begin to gun for other countries, likely targeting Spain, Austria, Italy et al. The obvious question is "where does it end?". There are German elections this year, and given the hardened public opposition to even domestic bail-outs or fiscal stimulus, it seems extremely unlikely that such a move (or succession, thereof) would be tolerated, and inevitable that this becomes a serious political issue.
Secondly, how should we trade such an announcement? The market is well aware of the above (and this is, in part, one of the reasons why the Euro has been under pressure of late), and will likely question the sustainability of such a bail-out policy, and consequently, the existance of the single unit itself. So sell the Euro on the announcement. But what about the adjustments required to regain competitiveness? The below chart shows a few REERs of EMU countries (based upon labour costs) relative to the Eurozone as a whole vs the levels at which they entered the Euro. I couldn't be bothered to do seasonal adjustments, but you can still see the broad trends: the ESP is about 35% overvalued relative to the DEM, the IEP is about 40% overvalued relative to the DEM and interestingly (and contrary to common wisdom), the ITL is about fairly valued with respect to the DEM.
There are some significant misalignments that clearly have to be rectified one way or another to reduce the magnitude of the area's current account deficits (Spain's is as large as 10% of GDP!). Specifically, the likelyhood of leaving the Euro is extremely low - even if the FX market begins to price in this probability - so this adjustment cannot be gained externally via default & depreciation. In which case, the domestic economies must undergo deflation in a similar manner to Latvia (which appears so far to be maintaining its peg to the Euro relatively credibly), which means that growth is going to crushed, making such trades as long DAX vs short IBEX potential winners (the spike in the chart below was the VW/Porsche hedge fund squeeze). Of course, policies designed to ensure fiscal restraint and crush domestic consumption are likely to result in significant social unrest (as we have already seen in Greece), and is likely to add to market fears.
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