Does economic policy uncertainty drive CDS spreads?

- We examine the link between changes in CDS spreads and economic policy uncertainty.
- In Europe, the relationship between these variables seems to be bi-directional.
- In the US context, changes in policy uncertainty lead the differenced CDS index.
- Shocks to the policy uncertainty notably increase the prices of credit protection.

This study analyzes the dynamic interactions between changes in economic policy uncertainty and the fluctuations in the cost of credit protection. We find that the differenced iTraxx and CDX indices are Granger-caused by variations in the political environment. Within a vector autoregressive framework, impulse response functions show a significant reaction of the CDS spreads to shocks in the policy risk. Implied in these findings is the possibility that country-level risk can permeate to the corporations. Furthermore, financial institutions and traders should closely monitor political developments in order to better predict the CDS premia.