Panic in CDS market to cause next collapse in equities
The Markit iTraxx Crossover index, composed of 50 non-investment grade European corporations, has breached 1,000 basis points, suggesting that a record number of European companies are on the verge of default due to deepening financial problems. This index was trading at 700bp a month ago and below 200bp prior to the credit crunch.
On this side of the
Driven largely by the optimism surrounding the $8 trillion worth of government rescue packages, the S&P500 has rallied 16% from its November lows. But, in an environment where even the key credit default indicator (i.e. the CDX North American investment grade index, CDX.NA.IG) shows signs of widening beyond 300bp (last at 270bp) within a matter of days, it is indeed difficult to see how any buying of equities can be justified. A parallel investment-grade index for Asian bonds traded at 440bp this morning.
In fact, any further widening of credit default swaps in the investment-grade and high-yield sectors will result in a panic rush for risk coverage. Already, risk insurance sellers in
So can the S&P 500 and Dow sustain their recent gains in the face of a 25% widening (from this juncture) of investment-grade and high-yield CDS spreads? And are some equity analysts generating a falsehood by advocating, implicitly or expressly, a fundamental disconnect between the growing crisis in debt on one hand and the bullishness in equities on the other? It might take some intense activity in the CDS arena to provide the requisite dose of reality but, leads and lags apart, look for the S&P 500 to be safely below 700 before any credible near-term bottom appears on the horizon.
Already, in the wake of the high degree of confusion cause by the flood of multi-tiered government-backed debt issues, sovereign risks on western nations have risen to levels which even seasoned traders could not have anticipated during the second-half of this year. The spread-gap between 5-year
To reiterate, here are the signals which will force sharp declines in the S&P 500 and the Dow: the CDX investment grade-index breaching 330bp and the CDX high-yield index breaching 1,600bp. Short equities (SPY, DIA and QQQQ) this morning.
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