The attached graphs demonstrate the massive rally in Sovereign CDS over the past few weeks, as well the collapse in the divergence in the VIX - Sovereign CDS pair.
The main reason for the Sovereign move has to do with short-covering as the Sovereign vs Financials trade came undone and hurt a few people comparing Sovereign risk to the senior-sub differential in financials.
After Lehman, the trade was short sovereigns vs. long corporates OR long financial seniors as risk was pushed to the state…last few weeks have seen that get hurt post the roll as financial risk has been assumed away. The green line shows the Senior financials over sovereigns risk and how well the trade worked from Lehman to mid Feb.
Senior-Sovereigns started taking profits and with liquidity dropping, Sovereign CDS rallied well as shorts covered – the differential gapped wider and Senior-Sov positions felt the pain and rushed for exits. That helps explain the disconnect between VIX and Sovereign CDS recently.
The rally in Senior Financials has also helped some still in the Sov-Seniors trade and in recent days there seems to be some movement back into it, although this time there is likely more of a balance between Senior-Sub decompression against Sovereigns.
Alternatively, this time look for a possible reinforcement loop between VIX and Sovereign CDS levels.
Hat tip Tim B
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