Economists and analysts looking for succor from tumbling equity markets and the specter of war with Iraq should beware the false optimism suggested by tightening credit default swap (CDS) spreads, warn derivatives market officials. While CDS spreads are an important indicator of the overall robustness of the economy, the CDS market may not always accurately reflect credit conditions more generally, explained Alex Reyfman, v.p. in credit derivatives strategies at Goldman Sachs in New York. The CDS spread is the annualized basis point premium demanded by the market in exchange for providing default protection.
CDS spreads have sprung to prominence as an economic indicator in recent weeks. Their predictive qualities were thrust into the spotlight after the Federal Reserve last Wednesday decided to leave rates on hold in part because of the recent improvement in corporate bond and CDS spreads, according to market officials. Indeed, the Wall Street Journal anticipated the Fed's decision on Tuesday, stating that Fed officials are taking some comfort from improved conditions in the derivatives market, and added that CDS spreads are a favorite market indicator of Fed Chairman Alan Greenspan.
CDS spreads are strongly influenced by factors specific to the derivatives market and therefore should always be viewed in the context of other financial instruments, said Goldman's Reyfman. For example, while loan hedging activity typically drives CDS spreads wider, the launch of synthetic CDOs will conversely cause spreads to tighten, especially in the five-year sector where the majority of synthetic CDOs are launched. Short-term movements in these spreads therefore often have more to do with product supply than the overall health of the economy, he reasoned.
David Skidmore, spokesman at the Fed in Washington, noted that world economists and analysts monitor a wide variety of economic and financial indicators including credit default swaps. Skidmore pointed towards a recent speech made by Greenspan in which the Fed chairman speaks of how credit default swaps are priced to reflect the probability of net losses from the default of an ever-broadening array of borrowers.
