By Rom Badilla, CFA – Bondsquawk.com

Credit default swaps on sovereigns decline before tomorrow’s European Central Bank meeting which is expected to keep short term rates at 1 percent.

Adding further fuel to relieve market concerns, Ben Bernanke testified before a House Budget Committee today suggesting that an economic recovery is still underway. While he expects GDP growth to rise to about 3.5 percent for the rest of 2010, he added that the recovery will be difficult for many Americans as unemployment remains fairly sticky.

European peripherals are witnessing CDS spreads, which is the cost associated with buying protection in the event of a default, decline. Greece’s 5-Year CDS is lower by 36 basis points to a spread of 785. Portugal spreads on the 5-Year contract is at 316 basis points, a drop of 32. Italy’s 5-Year is at 212 basis points, a decline of 31 while Ireland’s is lower by 26 to a spread of 258 basis points. Spain’s 5-Year CDS is lower by 10 basis points to a spread of 246.

Portugal 5-Year CDS Spread – Historical Chart (Before Today’s Activity)

While the contraction in default risk in CDS is encouraging, it is interesting to point out that government bond yields are displaying a different story as yields are mixed and more subdued. Greece’s 5-Year notes are higher by 4 basis points to 8.62 percent while Ireland’s is at 4.11 percent, an increase of 3 basis points. Portugal and Spain are seeing their lower yields though by about 7-8 basis points to 4.04 and 3.75 percent, respectively. Italy on the other hand is seeing much tighter yields as the Italian 5-Year is lower by 21 basis points to 3.01 percent. Comparatively, Germany’s 5-Year benchmark is higher by 5 basis points to 1.44 percent.

The Euro is advancing 0.6 percent to 1.2041.

Given the recent barrage of widening the past two weeks in CDS coupled with the subdued movements in bonds, I think its safe to assume that much of today’s spread compression in CDS is a result of short covering before tomorrow’s ECB meeting. Bearish sentiment in its many forms is an overcrowded trade and is due for a respite. Furthermore, headline risk across the globe (in either direction) is high given the recent volatility, so traders appear to be hedging their bets and are taking chips off the table for any surprise announcements.

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