High Yield

In line with our views on Europe's endgame, Marc Faber opined on Bloomberg TV this morning that if he "was running Germany, [he] would have abandoned the eurozone last week". We suspect that given the lack of real steps forward and no additional exposure (as yet) for Germany that they can hang on a little longer before they reach the final phase of the game-theoretically optimal exit (that Credit Suisse and us share) of a mercantilist GERxit occurring sooner than many think (benefiting from deposit inflows and low-EUR-based high profitability from exports for as long as possible and not a moment longer). The "cosmetic fix" of this latest summit, as Faber calls it, simply does not solve the fundamental problem of over-investment in the euro-zone. He is bottom-fishing in some European equities (though avoiding banks) and is not long the Euro here as he sees the modest rally in risk assets in Europe as merely a reflection of illiquidity and a grossly oversold market reverting on 'not a total disaster' though he reminds us early on that "pooling 100 sick banks does not make them healthy."

Concluding this week's series of very weak Treasury auctions is today's $29 billion auction of 7 year paper which despite pricing at a third consecutive record low yield (as more and more are frontrunning the Fed's implicit desire to buy up every US Treasury above 3 years in circulation) was actually merely the third consecutive auction to price with a tail. With the When Issued trading at 1.063%, the final high yield was 1.075%, sending off the first red light. Then the Bid To Cover dropped to the lowest since October at 2.64, which was not good either. Finally, the Primary Dealers once again were stuck holding more than half of the bag, or a take down of 51.48%, which was the highest since January, leaving just 42% to the Indirects and a very low 6.49% to the Direct bidders - the lowest since February 2011, and one can see why many are scratching their heads at the seeming strength of the secondary US bond market and the increasingly weak primary one.

We have discussed the use of correlation (cross-asset-class and intra-asset-class) a number of times in the last few years, most recently here, as a better way to track 'fear' or greed than the traditional (and much misunderstood) VIX. As Nic Colas writes this evening, a review of asset price correlations shows that the convergence typical of 'risk-off' periods in the market is solidly underway. While we prefer to monitor the 'finer' average pairwise realized correlations for the S&P 100 - which have been rising significantly recently, Nic points out that the more coarse S&P 500 industry correlations relative to the index as a whole are up to 88% from a low of 75% back in February. In terms of assessing market health, a decline in correlation is a positive for markets since it shows investors are focused on individual sector and stock fundamentals instead of a macro “Do or die” concerns.  By that measure, we’re moving in the wrong direction, and not just because of recent decline in risk assets.  Moreover, other asset classes such as U.S. High Yield corporate bonds, foreign stocks (both emerging market and develop economies), and even some currencies are increasingly moving in lock step.  Lastly, we would highlight that average sector correlations have done a better job in 2012 of warning investors about upcoming turbulence than the closely-watched CBOE VIX Index.  Those investors looking for reliable “Buy at a bottom” indicators should add these metrics to their investment toolbox as a better 'mousetrap' than the now ubiquitous VIX.

The last few days have seen high-yield credit markets remain remarkably resilient in the face of an equity downdraft.  Both HYG (the high-yield bond ETF) and HY18 (the credit derivative spread index) have remained notably stable even as stocks have lost over 3% - and in fact intrinsics and the underlying bonds have improved in value modestly. HY bonds are much less sensitive to interest rate movements (especially at these spread levels) and so, in general, this divergence in performance is aberrant (especially with equity volatility also pushing higher in sync with stocks and not with credit). So why is high-yield credit not so weak? The answer is surprisingly simple. As we argue for weeks from the end of LTRO2, credit markets were far less sanguine than stocks and have leaked lower ever since. This 'relative' outperformance of high-yield credit over stocks appears to be nothing less than the last of the hope-premium bleeding out of stocks and re-aligning with credit's more sombre 'reality' view of the world. Given the sensitivity of HYG (and HY) to flows, and the weakness in risk assets, we would suspect that outflows will now dag both lower as they resync at these higher aggregate risk premium levels.

Hours before Spain is expected to present the bank "assessment" from Roland Berger and Oliver Wyman on its comprehensive bank insolvency status, the country sold €2.22 billion of two-, three- and five-year government bonds, in a sale which saw solid demand but yields that are simply laughable and are completely unsustainable, culminating with a record yield on 5 year paper. Per Reuters, the Treasury sold 700 million euros worth of a 2-year bond, 918 million euros worth of a 3-year bond and 602 million euros of a 5-year bond, beating a target to issue up to 2 billion euros of the debt... In a nutshell: big demand for paper that will leave Spain pennyless. Not very surprising, and as Elisabeth Afseth from Investec summarized, "They got it away, it's about the most positive thing you can say about it." Elsewhere the German economy continues to deteriorate from carrying the weight of the PIIGS on its shoulders, with the Mfg PMI and Services PMI both missing estimates of 45.2 and 51.5, and printing at 44.7 and 50.3, respectively. This was a 3 year low for German PMI and now all but confirms that the economy will enter a recession at the next GDP update. But all this pales in comparison with the latest update of the Greek comedy where we learn that the three parties forming Greece's new coalition government have agreed to ask lenders for two more years to meet fiscal targets under an international bailout that is keeping the country from bankruptcy, a party official said on Thursday. This came a few hours after a German parliamentary group officially spoke against a time trade-off for Greece. Which means that beggas will not be choosers after all.

S&P 500 e-mini futures managed to get back above their 50DMA, fill the gap back to the 5/4 ugly-NFP print levels, and retrace 61.8% of the recent swing high-to-low ahead of tomorrow's hope-laden FOMC-print-fest. As we noted here, credit markets do not agree that QE is coming anytime soon and today's Gold deterioration suggests expectations for anything more than a twist extension are overblown (which we suspect would be a huge disappointment to a market only 4% off its highs and a VIX with a 17 handle earlier in the day. As the afternoon wore on and the incredible reporting falsehoods were denied, equity markets (and EUR) reverted lower (led by financials) pulling back to VWAP (and VIX pushed back rapidly to 18.5 - ending the day higher in vol (despite a 10pt jump in the S&P). Low volume and falling average trade size suggests this was far from the start of a new trend in stocks and the push higher (and steeper) in TSY yields to Monday's opening highs seems more like QE hope fading than growth hope. Silver just underperformed Gold on the day (both leaking lower) as Oil and Copper rallied (leaving WTI in the green for the week) as USD weakened and round-tripped to Monday's opening lows (with AUD now 1.3% stronger on the week). Investment grade credit remains a considerable underperformer relative to the high beta equity and high yield markets but 'agrees' with Gold and Treasuries in its view of no LSAP tomorrow- and the surge in implied correlation into the close suggests macro overlays as opposed to a market with any conviction.

Following the nationalization of YPF several months ago, Argentina's recent anti-private industry overtures largely fell off the map. Until the last few days, when bondholders of Spanish gambling company Company have seen their holdings seemingly disappear in a big Greece vortex (modern parlance for infinite drain of wealth): the reason - bonds plunged on speculation the Argentina gaming industry may be next to go under sovereign control. From Bloomberg: "Bonds from Codere, the Spanish gambling company that depends on Argentina for more than half its earnings, are the world’s worst-performing euro-denominated notes on speculation President Cristina Fernandez de Kirchner may seize the South American country’s gaming industry. Yields on the company’s 660 million euros of bonds due 2015 climbed 496 basis points last week to 18.97 percent. The performance was the worst among more than 2,000 securities tracked by BAML’s Euro High Yield and EMU Corporate indexes." The problem: should already highly leveraged Codere's Argentina operations be indeed nationalized, the bond will almost likely be Corzined, with recoveries which we expect will be comparable to those of Sino Forest.

Reasonable volume but decidedly low average trade size suggests today creep higher (and late-day acceleration) to Friday's closing level for stocks and bonds was more dead-cat-bounce (DCB) than BTFD. Treasuries sold off notably but in context merely retraced 50% of the high yield to low yield range from yesterday. S&P 500 e-mini futures (ES) also retraced perfectly 50% of the high to low swing of yesterday and closed almost to the tick at Friday's closing price. The USD drifted very gently lower today (-0.08% from Friday) on Cable strength (GBP) and the ubiquitous post European-close rally in EURUSD. The late-day AUD strength was probably the most notable (just what ES needed to get the correlation-driven asset up to unch for the week). Oil bounced ebulliently off its disaster lows of yesterday with WTI now only -0.8% from Friday as Gold, Silver, and Copper are up around 1.5% on the week (though gold lagged a little today). High beta equity outperformed - Materials, Industrials, and Financials up 1.5-1.8% as the major financials managed decent bounces - though all remain weaker than yesterday's open. Notably JPM's stock popped 3% while its CDS drifted wider still ahead of Dimon's denouement tomorrow. Equities outperformed credit today once again but IG and HY did rally/squeeze into the close - though remain cheap/wide to stock's exuberance. VIX stumbled about 1.5 vols but remains above 22% as cross-asset-class correlations fell notably into the European close but picked up in the afternoon as risk-assets in general led stocks higher - rather surprisingly syncing to fair-value at the close.

Whether it was the deterioration in Consumer Credit, downgrade rumors for US financials, Greek bank restructuring/run chatter, or a final realization that near-term QE is off at these levels of equity prices (as signaled by Bernanke and Gold this morning), the equity short-squeeze stumbled hard in the last hour of the day to end unch. Utilities managed to outperform handily as all the high beta sectors dumped into the close as Tech and Financials closed red for the day. Treasury yields and the USD were signalling considerably more equity weakness than we got though the dive caught stocks up but Gold remained the biggest loser of the day (-2% on the week against the 0.7% loss in the USD). Silver remains positive for the week - though matched gold's weakness on the day as Copper and Oil whipsawed up and down on rumor and then lack of follow-through. Equities pulled back closer to the underperforming investment grade (and less so high yield) credit market at the close. Treasury yields ended marginally lower (with the long-bond underperforming) and 7s and 10s -2bps)leaving 5Y flat still up 9bps on the week (and outperforming). Risk markets in general slid as Bernanke's speech was delivered and the Q&A proceeded but stocks went almost totally dead with financials and the S&P 500 e-mini clinging to VWAP as volumes died - until that last hour plunge. MS and BofA took the brunt of the selling pressure (ending down 3-4%) - though they are still well of the lows from a few days ago. VIX cracked back above 22% as we dropped in the end but closed down 0.5vols at 21.7% (and the term structure of vol has steepened up to 5mth highs) but implied correlation rose back over the somewhat critical 70 threshold and equities remain notably rich to broad risk assets in general still and today's huge jump in average trade size is somewhat concerning.

Three days after posting its biggest single-day loss in seven months, it makes perfect sense in this nonsensical market for the S&P 500 e-mini futures to post their best gain in six months (a 4-sigma drop to a 3-sigma gain). Volume was heavy (and we note came in size at the end). Financials went berserk with MS and BofA ripping around 8% higher along with Energy and Industrials all up near 3% today. The biggest jumps was pre-European close, but the very late day surge which just seemed ridonculous (and did disconnect stocks from other asset classes) dragged everything to close at the highs (with ES +2.25% and Dow +280pts). Just remind us why again? No meat from Draghi, but more pavlovian-bell-based hope for tomorrow's Bernanke speech? If that's the case, then why did the Beige Book's much-more positive tone than expected drive gold (QE-hope-fading) significantly lower and leave stocks and treasury yields, at their highs and the USD at its lows. Bonds are 18-22bps higher in yield this week now (with 5Y outperforming only 10bps wider as maybe the 5Y is now the new cash). Gold underperformed its commodity peers as Silver outperformed and Oil and Copper leaked higher with the weaker USD (now down 0.74% on the week). IG and HY credit underperformed as stocks (and HYG) took off into the close and CONTEXT (a proxy for broad risk assets) disconnected lower from equity's ebullience at the end of the day after being dragged higher for much of the day.

This chart, better than any we have seen so far, summarizes just how much has been injected already to preserve the Eurozone from collapse.

Headlines & stories from the day

While stocks, gold, and the dollar are generally in sync, Treasuries appear modestly more bearish now (for stocks) but it is the high-yield bond ETFs that is making a few people nervous as they plunge on heavy volume (and well below their intrinsic value). Obviously no-one really knows what i going on at JPM, but fort some more color we note that IG9 10Y is trading wider once again offered at 169bps - so one wonders if the liquidity in HYG is allowing some unwinds (or more hedges to be laid out). Certainly stocks remain ignorant of it for now - though month-end may be impacting both.

So the EC wants the ECB to bypass the EFSF and use the ESM to recap EU banks?  That was the rumor that shifted global stock markets by 1% in a matter of minutes? It has been awhile see we looked at the EFSF Flowchart or had a detailed look at the EFSF Guidelines but it looks like it is time to dig a bit deeper into what is possible and what is not. The ESM is not yet up and running.  There was talk that it would be done by June or July of this year, but in typical EU fashion I don’t think much progress has been made towards that promise.  So right now the EU is stuck with EFSF and the potential to set up the ESM. The market got carried away with the promise of LTRO as a sovereign debt savior, instead it created a potential death spiral. Spanish and Italian bonds are definitely getting crushed today, but with Spanish 10 years above 6.5% and Italian 10 year bonds nearing 6%, the potential for intervention rises.  The secondary market is affecting the primary market, which is driving up the cost of funds, creating more pressure on the budget deficits.  The countries are painfully aware of that, as is the ECB. 

Bank Regulatory Capital has been in the news a lot recently - between the $1+ trillion Basel 3 shortfall, the Spanish banks with seemingly their own set of capital issues, or JPM's snafu.  There has been a lot of discussion about Too Big To Fail (“TBTF”) in the U.S. with regulators demanding more and banks fighting it.  After JPM's surprise loss this month, the debate over the proper regulatory framework and capital requirements will reach a fever pitch.  That is great, but maybe it is also time to step back and think about what capital is supposed to do, and with that as a guideline, think of rules that make sense. Specifically, regulatory capital, or capital adequacy, or just plain capital needs to address the worst of eventual loss and potential mark to market loss. Hedges are once again front and center.  The only "perfect" hedge is selling an asset. This "hedge" is also a trade.  The risk profile looks very different than having sold the loan and the capital should reflect that.