Photographer: Alessia Pierdomenico/Bloomberg

European Credit Volatility May Trend Higher as Periphery Exposed

ECB protects the extreme right tails with ongoing CSPP.

Get set for a gradual increase in Europe’s credit volatility. A mix of technical and political factors may conspire to lead to greater swings in an index of credit-default swaps on investment grade companies, Bloomberg strategist Tanvir Sandhu writes. 

The Markit iTraxx Europe Main Index faces diminishing risk-reward for further tightening as peripheral bond spreads are exposed to widening pressures from rising political risks and the constraints faced by the European Central Bank in tweaking its bond purchase program.

Legal hurdles faced by the ECB due to risks of contravening the Maastricht Treaty’s prohibition of monetary financing may also push up volatility in the iTraxx Main index. ECB President Mario Draghi cited last month “an increasing awareness of legal and institutional constraints” on increasing the issuer limit on QE purchases from 33 percent.

One-month realized volatility on the iTraxx index is in the lower quartile of five-year range and may move higher as local volatility shocks may become more common.

While the ECB’s Corporate Sector Purchases Programme (CSPP) will prevent any blowout in spreads and protect the extreme right tails, investors may become reluctant to sell volatility given the rising political risks.

Italian bonds may trade more like credit instruments versus duration assets in the second half of 2017 to price risks of quantitative easing tapering in 2018.

Realized one-month volatility of Italian bond futures is at about 8, compared with about 4 in September, which was near the lowest levels on record.

Regression analysis of 10-year Italian bond yield spread over Germany vs 5-year iTraxx Main prior to ECB QE had R-squared (coefficient of determination) of 0.955 (y = 2.387x-21.228), while after has a R-squared of 0.056 (y = 0.359x+98.518).

Other risks that may squeeze longs include acceleration in issuance offsetting ECB buying, oil volatility and dollar-strength driven weakness in emerging markets.

Note: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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