Late Day Derisking As Sovereign Debt Crisis Is Becoming A Banking Crisis
The late day collapse in financials (thanks to Fitch's comments that seemed to wake up a stubbornly ignorant equity market to the reality that credit has been screaming for weeks) helped drag equities (and HY debt) significantly lower. Most notably, amid a much higher than average volume day today, the dislocations of the last few days - that we have highlighted - have converged very rapidly this afternoon. ES significantly underperformed a broad basket of risk assets (CONTEXT) into the close as copper and oil gave back some of the day's gains. TSYs closed at low yields for the day - and 2s10s30s dropped significantly - as we warned it would have to sustain any sell-off as EURUSD tracked back towards its lowest levels of the day dragging DXY up to almost unchanged on the day (+1.7% on the week).
It seems the combination of yesterday's VIX-Implied Correlation divergence and the dislocation in credit and equity once again provided some comfort that fears were rising. We do note that despite heavy cost of carry (and borrow) on HYG, it was clearly the weapon of choice for hedgers today and provided the early warning signal that trouble was coming.
The dollar was practically unchanged on the day - but +1.76% on the week as we note gold's selloff pulled it almost perfectly in line with dollar strength as silver's high beta nature dragged it lower. Oil and Copper enjoyed some attention today (QE and JPM) but gave back significantly into the close as risk was well and truly off.
Financials closed down 2.5% but it was the majors that lead the charge. We pointed to JEF's bond prices as signaling much more fear - and this afternoon we reiterated the recent underperformance of the majors CDS and bonds. This afternoon saw them start to converge to that uglier reality. MS is down over 10% on the week with Citi -8.4% with most of this action today (and in the last hour or two):
Compared to the tremendous weakness in Spanish and Italian banks, US banks have been relatively unscathed (and somewhat rightly so given lower leverage and less direct exposure) but there are plenty of transmission channels (via lending, credit growth, direct counterparty risk, funding needs to name a few) to bring that risk onto our shores. Remember in times of stress Gross Is Net!
And from Peter Tchir of TF Market Advisors, who has been very vigilant on the HYG market action, highlights the concerns that have seemed evident in credit markets - that this sovereign debt crisis is morphing rapidly into a banking crisis (a la Rogoff and Reinhart, we suspect).
While we wait for the ECB to begin unlimited printing we are seeing signs that more and more this is becoming a banking crisis in addition to a sovereign crisis.
Unicredit's earnings were a disaster - but actually had little to do with the sovereign debt crisis - those losses were from other dumb decisions made by them.
The landesbanks were downgraded - no surprise to anyone who has ever been on the other side of a trade with them.
Spanish banks are struggling to get even short term domestic funding - an their problems are far more real estate related than sovereign debt related.
Even with ECB intervention the bonds held by banks will still be at yields that have big unrealized losses couple with losses on the swaps they did to turn the positions into floating. Any hint that ECB printing (and I'm not sure they have really been sterilizing) brings inflation will hurt the banks who are in no position to add assets.
The new issue market is mediocre at best. Bonds come cheap. After a brief flurry in the "greys" they really don't tighten leaving the flippers with "cheap" paper they don't want to hold and existing bond holders afraid their bonds are going to get marked down to match the new issue spread/yield.
HY17 vs HYG on Thursday has performed well and shorting HYG yesterday morning has worked. I would take off the basis trade but would leave the short - seems like it has another point or two to run.
Italian long dated bonds are starting to look okay. Low prices, decent yields, and a captive buyer in a crowded short. I think shorting banks via CDS is good trade now, having started mentioning that last week, and that could continue to work well as the ECB can't bail them all out. Spanish and Italian banks and maybe even good old MS are ways to play it. I would still be short Spanish sovereign debt but think Italy really is a better long especially against Italian banks.
On a longer-term basis, HY markets are priced for an S&P around 1190 currently (and VIX around 37%) but as HY also collapses wider, we will rapidly see the 'expected' S&P level drop further. Credit Anticipates and Equity Confirms is often cited by old-school credit market professionals - it seems once again that it is true.
UPDATE: by request - there are a few ways to play the dislocations between equity and credit markets (as we discussed yesterday) but there are limitations on what instruments can be used (i.e. access to bond or CDS markets). In pure ETF space there are two approaches we have found useful - First, SPY Arb (which is a short-term intraday capital structure arbitrage model) - utilizing the relationship between SPY (equities) and HYG, VXX, & TLT (credit, vol, and rates). This is more for day-traders as it grabs intrday dislocations between the credit and equity markets based on a weighted basket. It is not always perfect and in sustained sell-offs like this afternoon - will tend to underperform - but offers a short-term medium-risk approach to the debt-equity market.
The second approach is what we call ETF Arb - it is a longer-term model of the relationship between stocks and the investment grade credit market. Holding periods tend to be days (at moist a few weeks) and it is a mean-reverting strategy. Today saw equities move to a very significantly expensive level based on this model - as the chart above shows. We believe that a short SPY vs Long LQD (short IEF) basket, weighted accordingly will be profitable as the relationship reverts back to its six month channel. The breakout, we suspect, reflects the equity market's hope for QE versus the credit market's reality check of the European and macro environment.
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