Implied Correlation

Treasuries at 7-Week Low Yields As HYG Signals Way Again

UPDATE: CONTEXT - the broad basket of risk assets has now caught up and is supporting post-stress-test equity weakness after hours as TSYs slide lower in yield.

Gold and Silver outperformed their less precious commodity cohorts today as equities (and credit in general) managed a see-saw day centered around a dud IMF-bazooka and more-of-the-same from the FOMC. Stock and Bond markets stayed in sync early on as risk was decidedly off this morning following the weak GDP print though we do note that IG protection was bid even as stocks managed a small rally across the open. Equity and CDS indices tracked each other (as liquidity in the latter is low this week already) but the IMF-credit-line news jagged both notably higher and out of sync with HYG (the high-yield ETF) once again, and then as the FOMC minutes offered little immediate hope of QE3, reality set back in and equity and credit markets drifted back to the reality of HYG's risk aversion. The late day plunge in ES on the back of the stress-test announcement is not being followed by IG, HY, or CONTEXT for now as Gold and Oil were flat, FX marginally lower USD though TSYs were the main driver of risk weakness ending at the day's low yields and their lowest yield since 10/05. Implied Correlation diverged upward from index vol into the close suggesting strong macro-protection demand even as VIX leaked lower. Equities remain in catch-up-to-credit-weakness mode and given the reaction to today's mini-IMF-bazooka, we suspect derisking is here for the week.

Commodities Up, Equities Unch, Credit Down

Following our earlier post, equities retreated and converged towards the reality of their credit cousins in the last 30 minutes to end only marginally higher (or practically unchanged by futures close). A 30pts rally off the overnight lows was far and beyond the performance of credit markets which never traded green all day but it was EUR weakness (USD strength) that was intriguing given the rally in PMs and commodities. Gold and Silver are very marginally lower on the week while Copper is up around 1% but it was Oil's outperformance on the day that was impressive as the gentle roar of printing presses was heard on both sides of the Atlantic (noting Brent in EUR trades at the top of its nine month channel). Implied correlation diverged (upwards) from VIX into the close suggesting macro overlays were more bid - which reflects also the bid for protection in CDS markets - and signals far less risk appetite than the headlines (until the last few minutes) suggested.

Italy Sparks Market Bloodbath: Financial Stocks Collapse

So much for the US decoupling. Following 5 days of persistent refusals to deal with reality, the real world finally came back with a bang, and while the overall market tumbled the most in two months, it is really financial stocks that took the brunt of today's beating. As the chart below shows, the XLF has literally collapsed with most major banks on the ropes, and the broker dealer index down 6.45% the most since August 10. The reason? Italy of course, and the fear that once the country is forced to write down its debt, the bank failures will proceed in waves: first Italian banks, then French, and then everyone else, especially those that have already been in the market's crosshairs for their exposure. And if today was ugly, tomorrow promises to be an absolute bloodbath with Italy deciding to proceed with the issuance of €5 billion in 1 year Bills into what may well be a bidless market.

Desperate Demand For Short-Term Crash Protection Pushes Implied Correlation Above 100%

In one of the more quirky results of the rush for short-term protection and macro overlays this morning, the price of index protection was bid so far above the 'fair-value' based on the volatility of the underlying S&P 500 index components that the implied correlation (a modeled measure of the relationship between index and single-name implied vol demand - often reflective of 'crash risk' sentiment) for Jan 2011 exploded above 100%. Yes, we know that is 'impossible', but the point being that last week's smash higher in equity (and credit), as we noted at the time, had the feel of hedgers capitulating which leaves today's growing tensions (European and domestic) enough to push nervous traders massively into liquid hedges (macro protection). The bottom-line is that demand for liquid 'crash hedges' moved from 'economically sensible' to 'at any price' this morning.

Modest Late Day Excitement Tops Quiet Day

FX markets have pretty much trodden water for the last 24 hours with admittedly a small USD bullish bias providing little ammo for any correlation-driven risk-asset moves today. Credit markets did wonder gently up and down but ES was like a Parkinson's patient off his meds as it noisily whipped up and down in a small range generally tracking credit. Into the close HY and ES surged (on nothing except perhaps the EUR futures CoT data) as MF Global's stock price dived but HY managed to hold and close at its highs while ES pulled back modestly. IG didn't play into the late day exuberance and we suspect the HY shift is more index arb as intrinsics actually widened on the day and the index remains cheap. HY is still 'cheap' as a risk asset relative to equities which might explain some of the grab here into the close but with a weekend of uncertainty ahead, why not wait til Monday to add risk? Copper managed to rally from pre-open today as did oil marginally but Silver and Gold were unimpressive as they held gains (much as DXY was holding its losses on the week).

Market Snapshot: What's Left?

What was already a relatively volatile morning as we lead up to the European close, paused for an hour or two until the FOMC statement was released. Immediately, stocks ripped and dipped, the TSY curve started to flatten - pivoting around the 7-10Y, the USD took off, commodities and PMs dropped, and credit cracked wider. Somewhat interestingly, while all this chaos was occurring, ES remained relatively well behaved with regard a broad basket of risk assets - which while not a positive per se, did indicate that this was a very broad de-risking and not simply an overly excitable US equity market prone to vicious dips, rallies, and retracements. It seems very obvious now, and fit with our indications of an exuberant equity market relative to the 2s10s30s fly, credit, and risk in general, that the rally in equities (which baffled anyone with common sense given the background of worsening macro data) was on pure hope and perhaps the sell-off's harshness today will have burned a few fingers as it seems the Bernanke Put strike just moved a lot further out-of-the-money.


UPDATE: Appended some equity-credit relative-value perspective.

S&P Options Making Room For Possible Downside

The weird and wonderful world of options markets and models can sometimes provide useful insights on a reflexive/contrarian basis if we know where to look. Everyone is used to reading/hearing about VIX (Pisani's Fear Index) which tracks a near-the-money relatively short-dated implied volatility (note upside and downside volatility not just downside - though volatility and price do tend to co-depend quite highly). There are many other 'implied' distributional measures one can glean from the broad array of liquid options prices. When all of these indications are at extremes, there is little chance of an extended downside move since broad swathes of investors are hedged and hence not feeling all the pain - however, with current levels having normalized modestly, any downside shock (no QE3 for example) could easily be exaggerated by unhedged forced selling.

Anatomy Of A Squeeze

While little has really been said or done this week with regard to solving any of the structural issues facing Europe, macro data globally has hardly been encouraging, and micro (earnings) have not aggressively beaten earnings, the equity and credit markets have ripped higher. While many have talked of short squeezes, which obviously are at the heart of every trend turn (whether micro or macro), we thought it useful to get some context on this move to judge when/if it will ever stop.

Market Snapshot - What Happened?

A perfectly timed rumor that not only was unprovable but has potential merit (though has no ability to successfully 'fix' any of the issues that are rightfully staggering global equity and credit markets), was enough, combined with some awesomely-ironic VWAP reversion volumes to take the offer stack in S&P futures and squeeze weaker shorts enabling a miraculous run to the green finish line in ES today. While this move did support (or was supported by) other asset classes - the broad risk-basket was not as excited and moreover HYG/JNK did not participate at all in the last 30 minute rip-fest.

Credit Underperforms As ES Misses VWAP Target Into Close

The algo-driven levitation of the last hour or so today seemed all about making it back to the magical VWAP line so more selling could occur but even though we were rising, average trade size  rose notably into the cash close which is very suggestive of pros selling into the lift (as deltas were definitely weak). This little burst was enough to drag equity into outperformance today relative to credit markets which had a very weak day.

Risk-On Drivers All Weak Today

Gold, silver, and the dollar performed well today and despite some early strength from equities, risk-on-related assets were set to pull equities lower calling the bluff of marginally better trade figures. Of course, with Swissy off the table from a safe-haven perspective (losing 2% against the USD today), gold benefited from the anxiety that Bernanke's 'shrug' provided. Unless the game-theoretic (bargaining) response from Republicans over whatever Obama proposes tonight is ignored, we suspect selling pressure will continue in equities as they adjust to life on their own for a bit.

Market Bloodbath, "Happy Birthday Mr. President" Edition

The Dow is down more than 500. The S&P is down 60. The VIX surges 35% to 32 the highest since June 2010. Implied correlation surges to the highest since last summer. ES volume surges to the highest since the flash crash. Europe is opening in 12 hours. Margin debt is near record high levels, and mutual funds have record low cash. Liquidations galore. Did we miss anything?

CapitalContext's picture

Top-down equities underperformed credit once again as day after day we see the QE2 froth being blown off the weak recovery beer. HY credit is at its widest in six months, financials CDS are starting to crack finally, and sector relative richness in stocks is beginning to sync back to credit.

CapitalContext's picture

Activity in spread land was very muted today with only a handful of names really making any moves. Equity outperformed credit but single-name credit was disappointing as up-in-quality continued. Primary issuance dominated thoughts today as 2s10s30s seemed to run S&P futures nicely up as credit ignored it.