Latin America CDS ... Risk Is Always On

Conclusion: CDS Spreads are widening from Europe to Latin America, which may spell near-term trouble for U.S. equities.


As my colleague Matt Hedrick pointed out in a note today, European sovereign CDS has risen 15-30% week-over-week for many countries, which is attracting some Manic Media attention back to Europe’s sovereign debt issues.


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Shifting gears to Latin America, we have seen a similar weekly up move in these CDS markets – most notably Venezuela and Argentina (up 112bps and 44bps, respectively). In what consensus is calling “risk-on”, these global CDS moves suggest risk is back in the global marketplace. We’ll take the other side of that statement, however, as risk is always on in financial markets.


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Broken down individually, we see that Venezuela recently agreed to pay debts to Colombian exporters in the area code of $800 million, which is obviously a large incremental strain on the country’s budget. In Argentina, things appear much worse and could be the start of a longer term issue that could lead the country to eventual default. The Argentinean Central Bank is boosting the amount of short term sovereign debt to absorb the excess liquidity from their recent dollar purchases. In this effort to reduce inflation, which has surged to a four-year high of 11%, the bank has boosted the nominal amount of short term debt sold in weekly auctions by 67% Y/Y! What’s worse, they are doing it at incredibly high rates. On August 10th the central bank sold notes maturing in 679 days at a yield of 14.8%, which is ~1430bps higher than 2-year U.S. Treasury notes. Regardless of how effective this proves to be in the short term, we’ll take the other side of Argentina being able to comfortably finance this unsustainable borrowing over the next two years – particularly in light of our bearish outlook for global growth.


Over the next couple of years we’ll find out whether Argentina is doing the right thing from a monetary policy perspective. What we don’t have to wait as long for is where the S&P is likely headed. On today’s Morning Call, Keith mentioned that he might not be bearish enough on the U.S. consumer – which is incremental to our street-low U.S. 2011 GDP estimate of 1.7%. While we aren’t yet ready to revise down our estimates, we still believe the S&P at these levels is a severe disconnect from the reality that is U.S. economic and fiscal health. The Latin American CDS markets agree with our assessment.


Using an equally-weighted basket of CDS spreads for six select Latin American countries, we found that moves in these credit markets are a decent proxy for the direction of the S&P 500 in the following week. The inverse correlation in this relationship has an r-squared of 0.72 over a 5-year duration, which is reasonably significant from a statistical perspective. Given the current week-over-week move in Latin American CDS, we can cautiously expect the S&P 500 to trade down from the current ~1080-1090 range next week. We express caution because, obviously, correlation does not equal causation. Keeping that in mind, the inverse relationship is what matters here as it relates to globally interconnected risk management.


Risk is always on.


Darius Dale



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