Many have argued that sovereign CDS markets ’caused’ the problems in Europe – as opposed to simply ‘signaled’ what was in fact being hidden by cash market manipulation. But as the IMF notes in a recent paper, there are times when the CDS market leads the cash bond market and other times when it lags. But as far as looking at risk in Europe and the US, based on a wonderful model that uses Markov-switching to predict what the probability of the world being in a low-risk or high-risk state, we are as ‘low risk’ as we have been since the crisis began. Each time that level of complacency was reached before, equity markets have rapidly sold off. What is perhaps most notable is the systemic compression of every risk indicator, first VIX (Kevin Henry and the fungible excess reserves of every prime dealer whale), then the liquid SovX index (via Greece CDS auction uncertainty and ‘naked’ short bans), then the Euro TED Spread (via LTRO), then individual Sovereign CDS (via Draghi’s ‘promise’). The result, the ‘free-market’ signal of risk is non-existent.
Look carefully at the Nov 2011 period onwards and the step by step compression of each risk indicator (from high probability of high-risk to low probability) – crushing the free market’s signals…
The last three times the ‘model’ was so complacent about risk, Q3 2008, Q2 2010, and Q2 2012, the S&P 500 rapidly lost around 40%, 17%, and 11% respectively.