Political instability breeds volatility

If anyone doubted that political instability can breed market volatility then this week's events would surely have persuaded them.

The US government is still in shutdown and the debt ceiling deadline is getting ever closer, so on the face of it not much has changed from the stat of the week. But the mood shifted discernibly on Thursday, when the Republican house leader put forward a plan to lift the debt ceiling temporarily for six weeks.

Talks were held between the White House and Republicans, with no agreement forthcoming. The apparent thawing in relations, though, boosted market sentiment and triggered a significant rally.

The Markit iTraxx Europe tightened 3.25bps to trade at 93bps, while the previous series of the index was quoted at 84bps, its tightest ever level (series 19). The Markit CDX.NA.IG index trade at 77.25bps, meaning that it had tightened more than 6bps over the course of two days.

The volatility was even more evident in US sovereign CDS, one of the most watched indicators in recent weeks. The one-year spread started the week at 52bps, by Wednesday it had widened to 68bps, then on Friday morning it was 17bps tighter at 51bps.

It later settled at 58bps, while the five-year tenor tightened 6bps to 34bps. Poor liquidity in the one-year contract no doubt contributed to the oscillations, but the uncertainty over political direction was surely an additional factor.

We might get news of a debt ceiling extension later today, over the weekend or not at all. If it is the latter scenario, then we can expect more volatility next week.

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