High Yield

"... a default cycle in commodity-related areas at this point is unavoidable, and the only real question here is whether it stays contained to those areas or extends itself to other sectors."

Government interference by both central banks and regulators (the latter are desperately fighting the “last crisis”, bolting the barn door long after the horse has escaped, thereby putting into place the preconditions for the next crisis) has created an ever more fragile situation in both the global economy and the financial markets. As the below charts and data show, price distortions and dislocations have been moving from one market segment to the next and they keep growing, which indicates to us that there is considerable danger that a really big dislocation will eventually happen.

Overnight market action has largely been a continuation of Tuesday's key themes with European stocks falling as a selloff in mining companies extended to a 7th day, even as metals prices rose and crude oil rallied modestly from a six-year low after yesterday's API crude inventory draw. U.S. equity futures have rebounded from modest declines, as emerging-market shares extended their losing streak to a 6th day while Asian stocks dropped to 2 month lows.

One can choose to ignore all these charts. However, many of them suggest eery similarity to 2007/2008 in structure. And if this structure plays out the so called "Santa" rally may not be all that it's cracked up to be. The cumulative message of all these charts: Things are far from well.

Considering the plethora of specials on the curve, which included both the 2Y, 3Y and the 10Y, it is hardly surprising that many took opportunity to cover the structural short headed into today's auction by purchasing paper in the primary market.

Last week we asked (rhetorically) if "something just blew up in junk?" We have the answer today, as triple-hooks (CCC-rated debt) in the junk bond market have crashed through the worst levels of 2011 and are now at the highest yields since July 2009. Amid this complacency still reigns in the equity market (just as it did when the last credit cycle turned).

With Draghi's Friday comments, which as we noted previously were meant solely to push markets higher, taking place after both Europe and Asia closed for the week, today has been a session of catch up for both Asian and Europe, with Japan and China up 1% and 0.3% respectively, and Europe surging 1.4%, pushing government bond yields lower as the dollar resumes its climb on expectations that Draghi will jawbone the European currency lower once more, which in turn forced Goldman to announce two hours ago that it is "scaling back our expectation for Euro downside."

"It is our humble belief that the consensus at the Fed does not fully understand the magnitude of the problems in corporate credit markets and the unintended consequences of their policy actions."

Optimism in US equity futures appears to have returned, and as of this moment US equity futures are higher by 9 points to 2060 as the attention shifts to what, according to BofA, is truly the most important ever. It is unclear just how the algos would take a second consecutive major disappointment in a row: should today's NFP print be well below the 200,000 consensus, December rate hike odd will tumble and the EUR will surge even more after declining modestly from overnight highs just below 1.10, leading to even more losses in European equities and spilling over to the US. 

"Like most turns in the credit cycle, it is uncertain exactly when the bottom will fall out of corporate credit markets, but the catalyst is likely to be an unexpected major event, perhaps even a single company getting into trouble. While we have been bearish on high yield for over a year now, we didn't think the conditions were yet ripe for a collapse. Now they're ripe."

- Ellington Management

The lack of fear in risky assets is another way of saying that risk premia have been low, or as we also like to put it, that complacency has been high. Not fully appreciative of this inherent risk, it seems many investors have refrained from rebalancing their portfolios, and bought the dips instead. We believe the Fed’s efforts to engineer an exit from its ultra-low monetary policy should get risk premia to rise once again, that if fear should come back to the market, volatility should rise, creating headwinds to ‘risky’ assets, including equities. That said, this isn’t an overnight process, as the ‘buy the dip’ mentality has taken years to be established. Conversely, it may take months, if not years, for investors to shift focus to capital preservation, i.e. to sell into rallies instead.