Capital Context Update: Themes in a Flat Market Week

From Capital Context

The dollar and its interplay with risk assets was likely the main theme of the whole week as we note EURUSD has fallen 850pips from last week's highs.

Rather surprisingly, equities and credit were close to unchanged on the week when viewed top-down. Today saw us close near the lows/wides of the day and week in equity and credit indices as the dollar levitated further still. Given all the tempest in macro, micro, and market dynamics, to end as close to unchanged as this is seemingly miraculous, but nevertheless, we try our best to discern what themes we saw working their way through these mysterious markets.

There was plenty on both sides of the bull-bear debate this week but it was the dominance of the USD-related risk asset movements that really provided the impetus for the intraday moves. Most notably, despite closing down very modestly on the week, S&P futures were very near the lows of the week, seemingly unable to confidently push above 1350 and the up-in-quality rotation in credit along with duration reduction, increased high yield dispersion, junior-senior divergence in ABX and CMBX tranches, and index vol diverging from single-name vol are all signals of a leaking confidence in anyone without a vested interest that equities can push higher.

We are not permabears by any means, and in fact our tactical asset allocation framework only shifted us away from equities in mid to late April for the first time in a while. However, we are extremely diligent at looking for signs that all is not well and we hope we have been vociferous in our attempts to educate and illuminate some of those signals over the last few weeks.

Macro and news-wise
, a number of surveys and indices showed significant weakness this week including the NFIB Small Business Confidence (perhaps most notably after its relative positivity) and the
Conference Board Employment Trends Index
which dropped the most MoM since April 2009. We did notice that April Rail traffic actually declined for the first time over a year which synced with the UCLA Pulse of Commerce Index unable to hold onto March's gains and declining in April. The jobs print this week did ease back off the wonkish spike from last week but the oft-coted (when it is dropping) foru-week average contines to rise to worrisome levels (though being our somewhat dysphoric selves we do point out was entirely seasonally 'created').

Both US and German exports rose more than expected according to data this week - which is positive - but China's trade balance was worrisome, and between their rate hikes and inflation rising in all the majors, it will be no surprise that we see at leat modest tamping on brakes from central bankers (aside from the Fed of course silly-billy). The drop in oil and commodity prices, as much due to margin calls as the snap shift in the EUR that squeezed so many, will likely help but please remember that in EUR terms, Brent is still up 42% from the time of Jackson Hole.

Europe remains a hotbed of contagion and concern as Greek riots expose reality to many of austere policies forced on an already young and revolting (in revolt we mean) crowd and even over here in the good old USofA, where we sit glued to Idol and subdued with Atavan, the government cutbacks are evident (government layoffs in jobs print and CSCO's ugly numbers).

From our glass-half-empty perspective, we saw little to cheer about and while earnings season continues to do well (with some disappointments) we cannot help but snicker under our breath every time a talking-head sugggests a forward earnings of $XXX and a P/E of YY as his reasoning for why we see S&P500 hit 1500 by year-end. The focus on valuation in isolation is naive at best and dangerous at worst - ask anyone who was projecting out EPS in 2007! Our frameworks take a reasoned approach to both the valuation side and risk side of the equation to somewhat obviously arrive at an outlook or expectation of excess return. We rely on bottom-up non-linear relationships between debt and equity markets and their fundamental factors.

Forgive the infomercial but as many of you have explained to us when we speak with you, your frustration with financial advisors and asset managers trotting out the same perspectives admittedly predicated with some comment on inflation/European contagion/Oil prices/Interest Rates with little attempt to quantify or incorporate these potential issues into a forecast is high as it should be. It appears to us that any risk to a forecast is simply viewed in a Bayesian binary sense by almost all of them - we think S&P will be at 1500 by year-end though a continued copmmodity rally could weaken this outlook we donot think it will happen! Sorry Rant Over!

All is not well under the surface
. In
Credit
,
IG and HY
sold off on Friday but remained in a quite narrow range of trading for most of the week. They
closed at the widest closes of the week
(1bps and 8bps off the tightest close on Tuesday) but eked out a small gain from last Friday's closing levels (IG -0.7bps and HY -4.5bps on the week). However, both
IG and HY saw the front of their curves flattening
(3Y was wider on the week in both cases) and
intrinsics
(the fair-value of the indices based on the underlyings)
all underperformed
and in
HY especially were actually wider
). As an aside, we exited the ETF Arb trade at a hdansome profit this week but remain in the ETF HY-IG decompression position - around 1% in the money in this low vol strategy.

The swings this week were notable but the chart shows bps moves in individual maturities of the TSY complex with steepening in general very clear (even as fwd 2s10s hits it upper channel).

Treasuries
saw the short-end of the curve relatively bid against the long-end with that disappointing 30Y mid-week. the fwd 2s10s curve remains very rangebound (we would expect flattening in the short-term) but it is clear from the Treasury complex shifts as much as from the relative shifts in CDS and corporate bonds that duration was being reduced as much as possible. The curve shift had a definite butterflky feel to it with the shirtest-end flat, the belly bid, and the long-end offered which - given ourt 2s10s30s carry-trade perspective fits with a weaker US equity market on an intraday basis should that trend persist.

The overall positivity towards TSYs was echoed modestly in IG corporates where we saw some quite noticeable bnehavior this week. A clear preference for higher quality names but most notable was the huge buying of very short-dated bonds (less than 1Y) relative to the rest of the curve.

The scramble for yield has met some balance and while leverage is possible, it seems duration is being reduced aggressively. A
Net $458mm was bought in maturities less than 1Y - more than double the buying across the entire rest of the maturity spectrum according to TRACE
.

Looking across the
vol landscape
we saw VIX manage to drop on the week - unusual given the small drop in stocks overall but you know by now that we need context to comprehend what is going on in VIX and given the small rise in implied correlation and the shift in high beta and low beta stock vols, it appears out theme of protecting your quality names with options and selling down your lower quality (albeit winners in many cases) is responsible. The
skew has shifted back higher this week
also in the index suggesting concern is growing but the
rise in implied correlation after being in a notable downtrend for a while suggest perhaps a shift away from the tri-party cluster we have been focused on
(Financials, Energy/Basic Materials, and Others) as a driver of this relationship and
instead a more macro hedge
(high correlation when crashes happen as everything moves down together?) is underway. Certainly the relative high to low beta vol changes suggest this is being set up for now.

Credit was favored over equities in Transports, Basic Materials, and Energy while stock investors preferred the safety of Utilities and NonCyclicals.

The
systemic desire for the up-in-quality trade is very evident in our contextual models
with the lower quality names seeing the most damage in credit (and especially credit impaired relative to equity for these names). The A to BBB region seems to have been the focus for much of this over the week with the very best names bid notably more in equity than in credit (which makes sense since the relationships become almost non-existent upat those tight levels of spread).

The sectors that stoof out the most on the week were Transports, Basic Materials, and Energy where credit outperformed relative to equity (beta-adjusted) and at the other end of the scale Consumer NonCyclicals and Utilities saw more favor in equities (safety bid) than in credit.

Low beta credit outperformed high beta this week in CDS land and also in stocks with low beta actually positive on the week on average while high beta names lost around 0.2% on average.

IG and the Equity/Vol/Skew implied IG have converged this week more or les but HY remains stobbornly wide. This lack of improvement tends to occur at credit cycle turns as credit leads.

Overall,
we saw equity converge with credit on the week
when we look at our relative-value frameworks but that relationship has become much stringer for investment grade credit than HY (which is unusual given the stronger theoretical linkages in HY to equity relkationships).

We typically see this kind of disconnect (HY remaining cheap while IG and stocks agree for a while) at a cycle turn in credit and given the plethora of buybacks, dividends, and some M&A this week, we think our caution recently has been proven correct.

HY3s5s remains elevated but has shown some flattening recently. We are not happy with the performance of this trade so far and suspect that while derisking is occurring, there is not enough pain to rotate entirely out of HY (hence duration reduction) given the relative lack of investable assets to fund flows.

This trend of HY fund flows does however seem to have created one thing which we appreciate - that is some dispersion among names. The systemic desire for the up-in-quality trade has dragged dispersion lower in IG credit (which we strongly advocate should be faded via a long IG, short insurers position).

HY dispersion remains worryingly high while the systemic up-in-quality rotation into IG is maintaining uniformity (watch insurers for opportunity).

However, as is evident in the chart, this has not been the case in
HY names - even though we saw some small moves this week, it remains notably more dispersed than would be relatively expected at these levels of spread and IG dispersion
. The cycle tends to be macro overlay at first signs of concern, implied correlation rises, then slow unwind of underlying longs - worst first - in a hope to be first out the door while maintaining some macro cover, then unwind the macro cover. This of course repeats but we are seeing it here as the wider names are discriminated against in the major indices. Of course, compression in IG will tend to bring its own shades of concern as dealers attempt to encourage levered positions into such tight spreads - watch for gappy moves in IG, heavy volumes of runs in swaptions, and keep an eye on the junior-senior tranche shifts in ABX and CMBX as they are moving (albeit illqiuidly) in a concerning manner for now.

In
Europe
, Main and XOver (in Europe) underperformed the US on the week, despite some sovereign risk compression, IG +0.5bps and XOver +2bps. Perhaps most notable was the 3bps of decompression in financials relative to a modestly tighter ex-FINLs - even as sovereign CDS rallied.

This was seen by many, who once again lack any context, as indicative that the market is sensing victory and the path is clear. This is absolutely not true! First the
EUR itself finally woke up and converged more realistically to SovX
(Sell EUR, Buy USD, Sell SovX protection has been the pain trade so maybe it finally started to work). Second, we have explained that there are very few real buyers of the PIGs debt currently (especdially ex ECB who confirmed their absence today) and that the fact that Sovereign CDS compressed as Bond spreads widened this week should help confirm what we have been saying - this is a
basis trader's market
. The tightening regulations and increasing event risk noise perhaps triggered some unwinds this week as we saw Greece, Ireland, Portugal, and Spain all see notable drops in their CDS-Cash basis (i.e. selling back CDS protection and selling back the bonds they had bought).

Third,
SovX intrinsics still trade extremely cheap to the index
(i.e. the individual components imply a wider SovX and so to arb this spread which has come in this week, investors would sell single-name sovereign protection and buy the index protection. Put these together and you have a technical that is pressuring SovX tighter (EUR compression hedge), which leads underlying sovereign CDS tighter (from index arb) which are also aided by basis trade unwinds (PIGs were all net higher in spread to bunds on the week).

Interestingly, away from core European sovereigns, we saw CEEMEA names mostly wider (as oil fell) as well as most of EM and Asian Sovereigns. Turkey, Ukraine, Russia dominated the CEEMEA moves (clearly oil-related as we have stated before - there is close link). Staying in
Asia
, Vietnam was worst this week in sovereigns but our Asia-Ex-Japan (AXJ) versus Japan compression trade kept on going in our favor by around 2.5bps - slow and steady wins this race.
Australia
was flat on the week top-down but evidently it was financials that underperformed (led by Macquarie Bank) as non-financials compressed (again helping our trade there).

Bottom line
for us is that macro prints are not encouraging anything other than a slowdown in economic recovery and while equity bag-holders remain active on lower and lower volumes, the rest of the investing class is reducing risk, rotating up-in-quality and up-in-capital structure (i.e. from equities to bonds), is reducing duration overall, and is discriminating significantly among any idiosyncratic investments they make. Stay hedged in the A-List, watch HYG-LQD, and start rotating away from your winning momentum plays in equities if you have any left on the books. Credit has warned and equities will confirm.

Index/Intrinsics Changes for the week

CDX16 IG
-0.71bps to 89.54 ($0.04 to $100.39) (FV -0.09bps to 88.92) (51 wider - 67 tighter <> 67 steeper - 58 flatter) - No Trend.



CDX16 HVOL
-2.8bps to 148.4 (FV +0.53bps to 148.31) (14 wider - 13 tighter <> 16 steeper - 14 flatter) - No Trend.



CDX16 ExHVOL
-0.05bps to 70.95 (FV -0.29bps to 70.86) (37 wider - 59 tighter <> 45 steeper - 51 flatter).



CDX16 HY
(30% recovery) Px $+0.19 to $102.88 / -4.6bps to 429.7 (FV +6.47bps to 417.89) (64 wider - 35 tighter <> 35 steeper - 64 flatter) - Trend Wider.



LCDX16
(70% recovery) Px $-0.22 to $101.375 / +5.53bps to 242.85 - Trend Wider.



MCDX16
+6.38bps to 124.88bps. - Trend Wider.



ITRX15 Main
+0.52bps to 96.52bps (FV+0.09bps to 99.68bps).



ITRX15 HiVol
-0.41bps to 133.09bps (FV-0.52bps to 132.78bps).



ITRX15 Xover
+1.82bps to 354.82bps (FV-0.88bps to 345.79bps).



ITRX15 FINLs
+2.92bps to 135.92bps (FV+0.94bps to 134.86bps).



DXY
strengthened 1.3% to 75.81.



Oil
rose $2.26 to $99.44.



Gold
fell $1.25 to $1494.35.



VIX
fell 1.33pts to 17.07%.



10Y US Treasury yields
rose 2.5bps to 3.17%.



S&P500 Futures
lost 0.04% to 1334.

Spreads were tighter in the US as all the indices improved this week. IG trades 2.6bps tight (rich) to its 50d moving average, which is a Z-Score of -1s.d.. At 89.54bps, IG has closed tighter on only 43 days in the last 609 trading days (JAN09). The last five days have seen IG flat to its 50d moving average. HY trades 10.6bps wide (cheap) to its 50d moving average, which is a Z-Score of -0.4s.d. and at 429.68bps, HY has closed tighter on only 42 days in the last 609 trading days (JAN09). Indices generally outperformed intrinsics with skews mostly narrower.

Comparing the relative HY and IG moves to their 50-day rolling beta, we see that HY outperformed by around 2.1bps. Interestingly, based on short-run empirical betas between IG, HY, and the S&P, stocks underperformed HY by an equivalent 5.2bps, and stocks underperformed IG by an equivalent 0.9bps - (implying IG outperformed HY (on an equity-adjusted basis)).

Among the IG16 names in the US this week, the worst performing names (on a DV01-adjusted basis) were Toll Brothers, Inc. (+7.93bps) [+0.06bps], Metlife, Inc. (+6bps) [+0.05bps], and MDC Holdings Inc (+5.79bps) [+0.04bps], and the best performing names were Safeway Inc. (-7.39bps) [-0.06bps], Lowe`s Companies, Inc. (-3.69bps) [-0.03bps], and GATX Corporation (-3.07bps) [-0.02bps] // (absolute spread chg) [HY index impact].

Among the HY names in the US, the worst performing names (on a DV01-adjusted basis) this week were K Hovnanian Enterprises, Inc. (+215.15bps) [+1.54bps], Sabre Holdings Corp (+106.35bps) [+0.97bps], and PMI Group Inc/The (+121.02bps) [+0.94bps], and the best performing names were Dean Foods Co. (-78.42bps) [-0.75bps], Community Health Systems Inc (-28.85bps) [-0.28bps], and MBIA Insurance Corporation (-37.1bps) [-0.26bps] // (absolute spread chg) [HY index impact].

Comments

[DavidC]

I can say it it in 4 words and a number.

Nothing has changed since 2008.

DavidC

[CPL]

Flat?  Wait until monday.  Short it all or go x3 etf BEAR. 

Retard, the signs on the wall not enough to lead you to a bathroom?  If you own a hedge fund dump and run, dumb shit.

[rocker]

+1

[FOC 1183]

At one point this week, the 24 hour rolling correlation (based on 1 minute closes) between ES and AUD:JPY cross was 94 fucking percent.  If that's not the byproduct of automated quant (i.e. no subjective thought), I don't know what is.  I hope they're enjoying picking up pennies because the steam roller will leave quite a headache.

And, you can't write "From our glass-half-empty perspective" on a Friday night post.  It makes me very uneasy.

[Dollar Bill Hiccup]

You should finish the other half of the glass then. It's a single malt scotch ...

ES and AUDJPY, it's like watching computers masturbate. Yes, that's more disturbing than half empty ...

[FOC 1183]

Nah, after 5 18 hour days of watching (trading against) the masturbating servers....I'm going straight for the absinthe. I may not have an ear when I wake up, but at least I won't be looking at tick charts and correlation matrices.

[Clowns on Acid]

Absa_feckin_inthe.....

[Zero Govt]

...recently legalised again in France ..yes they're fuked too!