China CDS Breakout Predicted FXI Breakdown, Sovereign CDS Info (Charts)

According to Bloomberg, China's 5Y CDS rate (credit default swap) closed at 167 basis points yesterday, which is $167,000 to insure $10 million of Chinese government bonds per year. It peaked out at 201 basis points on October 3, 2011. On August 10, I posted that China 5Y CDS broke out to early 2009 levels at 113 basis points and said it looked exactly like the inverse of FXI (iShares FTSE China 25 Equity Index), which was testing 2010 support at $35.

China 5Y CDS vs. FXI (source: Bloomberg.com)

I don't trade credit default swaps, but charting out CDS is a great way to measure market risk because speculative trading, or hedging, default risk in the CDS market is essentially controlled by large financial institutions, banks and their clients (hedge funds) in over-the-counter trades (off-exchange bilateral contracts). CDSs are also used to correlate with other assets (there are Saudi Arabia CDSs but no underlying debt!). So technically, liquid or not, China 5Y CDS looked like a decent setup for a potential breakout when it was testing ceiling resistance in that two year sideways channel. And it eventually took off, see below. Did someone ride China 5Y CDS from 100 to 200 and sell the contract for a quick double? "The net value of outstanding credit default swaps on Chinese sovereign debt" is $8.3 billion, according to FT.


China 5Y CDS (source: Bloomberg)

So, as noted above, FXI was testing $35 support in August and looked like there was a possibility it could follow the move in China 5Y CDS. But instead of breakout, FXI would breakdown since their charts are inversely correlated at the moment. And boom, FXI broke through $35 support and hit a low of $28.61 on 10/4/2011. I was trying to find large put option activity at the $35 strike, but nothing really stood out. Those puts made a killing though. In September, the FXI October $35 Put traded between $1.0-2.0 and it hit a high of $6.46 on 10/4. Similar action occurred in the FXI November $35 Put. Side note: I remember last year reading this article in Bloomberg Magazine titled "Finding Stock Clues in CDSs: Credit-default-swap prices can provide hints about a company's financial strength that may not be reflected in its share price" (twitpic).


FXI iShares China 25 Index Fund (source: Bloomberg)

News and data were confirming economic growth risk in China with HSBC PMI reads under 50, inflation and toxic debt building up at the local government level and ongoing monetary tightening, which I believe were the catalysts that doubled China 5Y CDS in two months. The Shanghai Stock Index was trending down since it peaked in 2009 and it broke down in June, so economic weakness was being priced in. It is testing 2010 support as I write, and an arm of China's sovereign wealth fund just announced they are buying shares in state-owned banks (are they trying to defend support?).

I'm still not 100% sure why China 5Y CDS was singled out to play China's economic risk recently. I was thinking traders were betting on the risk that China's government would have to bail out its banks and local government financing vehicles because of toxic debt on their books from infrastructure and real estate loans. According to Zero Hedge, sovereign CDS also prices hyperinflation risk (via printing money), which is the reason why CDS contracts are denominated in other currencies and why sovereign CDS rates have been rising faster than government bond yields (the basis). Meaning the risk free rate is BS! But since China CDS is denominated in U.S. Dollars, gold ultimately wins in the end, right? I found articles at Zero Hedge and FT Alphaville that explain how the sovereign CDS market works and who trades China CDS.


It seems like CDS, used strictly for speculative directional trades, has been the easiest way to make money during the past six years (volatile credit environment). Those mutual fund returns would have looked nice. Did Paulson & Co. ever buy sovereign CDS after he made billions betting on the ABX Index, a synthetic CDS index referencing subprime mortgage-backed securities? According to Absolute-Return+Alpha, Paulson's Advantage Plus fund was down 46% "after a brutal September". I wonder if he's betting on PrimeX, the synthetic CDS index referencing prime mortgage-backed securities. Here's a list of market participants that trade sovereign credit default swaps. When will these contracts be available to retail investors on OptionsXpress or Interactive Brokers? Boo yah?


Recent articles out on China:


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