Sovereign Credit Risk, Commodities Crashes, and Correlations in Under 140 Characters

Think talking about commodities and credit risk is hard? Try doing it in 140 characters or less. A friend of mine, Tim Backshall of Credit Derivatives Research, and I had the following discussion on Twitter. I’ll translate where necessary:

Here’s the document on Scribd he referred to:

Translation: a negative basis occurs when you have a divergence between a CDS spread and a bond spread. Normally these spreads should be around parity, probably a slight positive basis with bond spreads slightly tighter than CDS. But if it reverses, and you have a negative basis (CDS spread is tighter than the bond spread), you’re getting a trade where you get the yield on the cash bond and the CDS hedges the credit risk so you have a trade that is almost riskless. The following paper describes basis trades in depth:

At any rate, the doc Tim refers to shows the compression between both sets of countries. My instinctual response?

My explanation is simple: Brazil and Russia have sizable reliance on commodity exports and China is the largest gold producer. They have a large portion of the world’s population, and they’re not aging as rapidly as the Japanese and Western countries so they have a secular wind to their backs. But they still need people to buy what they produce and a collapse in commodities.

Tim’s response:

Mine follows:

Wasn’t thinking about China’s gold production.

Tim:

I gave him a response that’s unintuitive at first blush, but I’ll explain it:

CDS liquidity is a bit different than other instruments. The most liquid names are the ones where the credit/default risk is highest. So illiquidity here can be an indicator of strength.

The document being referred to:

Here’s a little tidbit from Tim about what this shows:

In an effort to show just how dramatic a shift there has been in risk in developed nations relative to emerging and less-developed nations, the chart compares SovX (an index of 15 Western European ‘developed’ Nations), EM (an index of 15 Emerging Market Nations), and CEEMEA (an index of 15 nations from Central and Eastern Europe, Middle East, and African Nations).

The SovX is mostly represented by the PIIGS (65%), and Venezuela, Turkey, Argentina and Brazil combine to account for more than 62% of the EM index. Turkey and Russia make up 49% of the CEEMEA index. When you add Hungary and Ukraine, you’ve essentially captured two-thirds of the risk.

But as Tim explains, there is something you have to be mindful of when you look at these indices:

It would appear that the CEEMEA and EM sovereign risk indices are threatened more by commodity price pressures than credit risk currently – and given the ‘relatively’ high price of oil/gas, their risk remains less of a concern than developed nations where the Ponzi appears to be in question.

A number of these countries are exporters of natural resources so they rely on price stability in commodities to make their economies grow. I say stability as opposed to rising prices because if we’ve seen it once, we’ve seen it a thousand times. Rising prices – and parabolic prices rises in particular – condition people to expect further increases which we all know can’t be sustained. The economy becomes intertwined through the use of debt so when prices fall, the ability to service the debt in the economy is called into question and prices of non-correlated assets all fall simultaneously. Can’t you tell I’ve had my coffee?

Since Tim was on a roll by now, I wasn’t going to dissuade from his research:

And now the document:

Do I really have to say anything about this?

Of course, I had a response. After all, I got a hat tip:

All of which points to a rally in the US Dollar, because of the negative correlation between commodities and the greenback. But there is another currency that could fill the role of a hedge currency, and in reality it should be a better hedge.

If only their government saw it that way too…

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