The bank’s analysis, which is based on Didier Sornette’s research into bubbles (think US housing and oil circa 2008), holds that recent increases in CDS spreads in both US and European markets have reached unsustainable levels and are due for a correction - sharpish.
Per the report, by Peter Cauwels, Ken Bastiaensen and Amjed Younis:
Based on our findings, it is likely that the peak for the 4 major indices will be reached between the 2nd and the 12th of February, and as a result they will fall. This is particularly significant since these indices are closely watched as a “fear gauge” for Financial Markets, alongside the VIX Index, Libor-OIS spread and the spread between German bond yields versus other Euro Area government yields.
Their conclusion is based, in part, on the application of the mathematical model of Sornette’s general theory of crashes, which they backtested using the performance of the US dollar weighted average as a data series:
On December 5th, the toolset detected a bubble-like behavior and reported December 10th as most likely crash
Starting on December 9th, the DXY began a consecutive drop of more than 8% until December 17th. This drawdown13 was the largest since the start of the daily DXY index in 197114 and can thus statistically be considered a crash.
In addition to this forward test, a wide range of historical crashes15 have been analysed and the results used for calibration.
The formula, which according to Fortis represents a so-called “log periodic power law” (LPPL) and is given by:
p(t) ≈ A + B(tc - t)-β + C(tc - t)-β cos(ω log(tc - t) +ϕ )
Fortis believes four of the major CDS indices - the iTraxx Crossover and Main, and the CDX High Yield and Investment Grade - which all recently hit record highs, show a ‘bubble-like formation in spreads’, per the graphs below:
As for just what a bubble in CDS means:
… in the case of CDS, the spread can be viewed as the cost of buying protection against default and the bubble can be interpreted as a rush to buy protection at ever spiralling prices.
The fundamental picture does add weight to the thesis that the cost of protection could be overvalued. Viewing the implied probabilities as the breakeven levels when buying protection can be useful when assessing the value of CDS protection. For example, the iTraxx Crossover index is a 5Y contract that implies a projected default rate of 60% over the coming 5 years for the constituent companies 16.
The implied probability of default embedded in the spreads is higher than the realised default rate during the worst point in the Great Depression, and is higher than the 15.1% global default rate for speculative grade names projected by Moody’s for 200917. For European speculative grade issuers this is expected to rise to 18.3%. However this figure is not directly applicable to the iTraxx Crossover since the index also includes low investment grade names which normally have a lower default rate.
A correction would therefore portend the return of risk appetite and improved investor confidence.
Mark your calendars, then.