IG Hangover As HY and TSYs Underperform On A Slow Equity Day
An oddly calm day at the headline equity market level hid some relatively interesting moves under the covers. With ES practically unch from last night's close and this morning's day session open having traded in a narrow range amid 'average' volume, credit markets were more volatile with investment grade credit spreads outperforming and HYG (the high yield ETF) significantly diverging from high yield spreads, which underperformed today. The unusually high IG volatility today suggests hangover short-covering and gamma (option-related) pain remained. Equities remain rich in CONTEXT to global risk assets but both were stable today with modest downward pressure in stocks and upward pressure in risk. Of the main risk drivers, TSYs (dramatic underperformance) and commodities were the more volatile drivers while the relative stability of FX carry helped hold ES flat. Copper ended the day worst as Oil, Silver, and Copper grouped themselves around the modest move in the USD today, with Silver well off overnight highs and Oil well off lunchtime lows (just above $100 at the close). Traders appear to be working through the reality of yesterday's news and market action (especially on credit desks) and are waiting for NFP to re-risk as implied correlation once again suggested equity index protection was modestly bid - even as VIX stabilized from gap-down opens.
IG credit outperformed as remnants of short-covering and option-hedging issues hungover it. HYG also outperformed - notably away from HYG. See below for a deeper-dive into the HYG-HY-Index relationships and a discussion of somewhat arcane but relevant details in this market. ES (the S&P 500 e-mini futures contract) stayed relatively rich in the CONTEXT of pre-bailout global risk-assets (see chart below), but held relatively stable in the new regime (calibrated to post bailout micro-structure) which can be seen here as it converged into the close. [note: CONTEXT is an indicator based on a broad basket of global risk assets designed to provide a quick-and-dirty perspective on where equities trade relative to risk appetite in general]
FX was relatively flat with AUD underperforming relative to USD and CAD outperforming as most of the other majors were flat on the day. Commodities were probably the most volatile instruments of the day with decent swings in Silver and Oil and Copper disappointing.
TSYs were also volatile, saw selling pressure most of the day (repatriation again?) and notable steepening in the whole curve. 2s10s30s rose notably early on but dropped back a little into the close. The cancelled POMO may have upset some today but TSYs were definitely a busier market than most today with 30Y now some 17bps higher in yield on the week.
All-in-all, today was dominated by getting-a-handle-on-exposures in our view but the TSY performance is most notable/worrisome as is the HY-HYG divergence and credit market reactions today with net-buying in corporate bonds - with only the 1-3Y segment seeing net-selling.
A few have requested some more color on the verbiage and goings-on in the credit markets - we hope the following helps a little...
HY and IG Credit Market Technicals (Supply/Demand Flow) Thoughts
Since Friday, the HY credit derivative index (HY17) has swung violently from trading at a considerable discount (much wider spread) to its intrinsic value (the value of the index if you created it manually via the underlying 100 (or less) names). The discount reflected a demand for more liquid macro protection (as well as an 'easier' short) - its easier to buy (scramble for) index protection than spend the time to pick and choose each name and hedge/sell. Furthermore, for positioning, its much more liquid than the underlying names and easier to trade in size. [Note - the index and its underlyings, unlike in the case of the S&P 500 index components and SPY for example, are not 'easily' arb'd in real-time and different supply-demand technicals will impact each side (and allow insight into what is going on).]
The point being that the collapse in the skew (the spread between Index and Intrinsic) has been significant and now stands at a premium. The underlying names infer that HY17 (the index) should trade wider than it does for the first time in over a month and starting to get close to levels at which arbitrageurs may find value (and buy it back). We suspect that is what was occurring today as HY dramatically diverged from HYG in the afternoon (and underperformed intrinsics).
HYG (the high yield bond ETF) underperformed broad markets and HY credit today. While there is plenty of chatter about shorts covering and being squeezed out - which makes perfect sense - we note that HYG's short interest has fallen for over a month and it closed last night at a significant premium to NAV (swinging back from a major discount last week).
On the other hand, IG17 (the investment grade credit index) trades at a premium (tight spread) to its fair-value but notably has dropped to its richest to intrinsics in almost two months here - a huge 10bps (on an index that trades around 130bps). This suggests a huge short-covering squeeze yesterday that carried over into today. We would expect index arb traders (who profit from this differential) to swoop in soon at these near-record levels which will pressure the index wider.
A further reason for the relatively large jump and richness in IG is the sell-side has been vociferously pushing traders to buy option overlays. The 'puts' they buy make some sense obviously, but in an environment where markets are gapping wildly, the management of the delta hedge to keep the overlay 'neutral' becomes very painful leading to selling into downturns and buying into upswings exaggerating moves against your position - so called 'Gamma'.
The point here being (of this long-winded hopefully educational diatribe), there are a lot of painful technicals impacting the credit market currently that make comparisons very hard and we worry that this will reduce liquidity and further reduce market efficiency. It was evident today, in our humble opinion, that traders were very much sitting on their hands (or getting flat) in all markets as opposed to chasing new risk positions aggressively. Another unintended consequence of the ongoing intervention is smaller trade size, smaller risk budgets, and reduced liquidity - whether bullish or bearish, this does not help the engine of what is supposed to be a recovery - credit creation.