Investment Grade

As the S&P 500 reaches new multi-year highs and VIX touches multi-year lows, there is one rather large and risk-appetite-proxying market out there that is not as excited. The high-yield bond market has seen record in-flows dropping off recently and for the last four-to-six weeks high-yield spreads, yields, and bond prices have been very flat as stocks have surged ahead. Despite US earnings yields at near-record highs relative to high-yield bond yields, we see little pick-up in LBO chatter suggesting a notable preference for higher-quality junk credit (and/or lack of belief in sustainability of earnings yields) and the recent 'dramatic' outperformance in investment grade credit is a notable up-in-quality rotation (as well as early spread-compression reaction to Treasury weakness recently) that strongly suggests less risk appetite among real money managers (given how 'cheap' high-yield appears across asset classes). Lastly, the ratio of HY bond prices to VIX is near its extreme once again, something we saw occur before the risk flares of 2010 and 2011 surrounding the end of the Fed's QE sessions.

Between our overnight discussion of the size of the Fed's QE and Goldman's call for QE as soon as April, risk assets all synced and surged today as the USD gave back most of the week's gains. The S&P 500 managed to close above 1400 for the first time since June of 2008 on decent volume - even as AAPL closed down 0.7% (and -2.5% from the $600 threshold it peered over) as financials once again took the lead. BofA is now up 13.6% from pre-JPM-dividend news (more than double its peers) while GS and C languish up only around 2% from that point. High-yield credit markets were nothing like as QE-ebulient as stocks today as investment grade outperformed (more up-in-quality rotation) and the last 45mins actually saw active selling in HY and HYG while IG and the S&P leaked higher. Treasuries steepened very modestly with the long-end maybe 1bp higher in yield close-to-close but the 7-8bps compression off overnight high yields is noteworthy and brought the broad risk asset complex back in CONTEXT with stocks (after yesterday's dislocation). The USD lost around 0.4% from late last night on the day (though still stronger on the week) as EUR and JPY tracked it broadly but higher yield AUD outperformed handsomely (more QE-funding currency needed). Commodities bounced nicely with Copper the day's winner followed closely by Gold and Silver (up around 0.9%) and Oil practically unchanged after dipping over 1% on the SPR chatter and recovering on the denial. VIX ended the day (spiking) higher and the term structure very slightly flatter. After spiking Friday and Tuesday (as we broke the uptrendline) average trade size has drifted notably lower and was its lowest in over a week today suggesting less institutional buying here.

Without a doubt, retail has fallen in love with corporate bonds.  Fund flows were originally into mutual funds, and have shifted more and more into the ETF’s.  The ETF’s are gaining a greater institutional following as well – their daily trading volumes cannot be ignored, and for the high yield space, many hedgers believe it mimics their portfolio far better than the CDS indices. The investment grade market looks extremely dangerous right now as the rationale for investing in corporate bonds – spreads are cheap – and the investment vehicles – yield based products. With corporate bonds spreads (investment grade and high yield) already reflecting a lot of the move in equities, it will be critical to see how well they can withstand the pressure from the treasury markets.

UPDATE: The UK outlook change has had little reaction so far: TSY yield down 1-2bps, gold/silver bounced up a little, and a small drop in GBP.

While most of the talk will be about the drop in precious metals today, the sell-off in Treasuries is of a much larger relative magnitude and yet equities broadly ignored this re-risking 'signal'. At almost 2.5 standard deviations, today's 10Y rate jump (closing it above the 200DMA for the first time in eight months) trumps the 1.3 standard deviation drop in Gold prices - taking prices back to mid-January levels. According to our data (h/t JL) for only the 14th time in the last five years (and not seen for 16 months) Treasury yields rose significantly and stocks fell as the broad gains in yesterday's financials (on the JPM rip) were held on to at the ETF level but not for Morgan Stanley, Goldman Sachs, or Citigroup (who gave all the knee-jerk reaction back). Tech led the way as AAPL surged once again (though faltered a few times intraday) having now completed back-to-back unfilled gap-up-openings. Credit and equity were generally in sync until mid afternoon when the up-in-quality rotation took over and stocks and high-yield sold off (notably HYG - the high-yield bond ETF underperformed all day long) while investment grade credit rallied to multi-month tights. VIX bounced higher (notably more than the S&P would have implied) recovering to Monday's closing levels and back above 15%. The Treasury sell-off was 'balanced' in terms of risk-on/-off by the strength in the USD (and modest weakness in FX carry pairs as JPY's weakness was largely in sync with the rest of the majors - hinting its was a USD story). Oil and Copper both lost ground (as did Silver - the most on the day) though they tracked more in line with USD strength than the PMs.

The general dogma seems to be that the recent Treasury weakness reflects either a) risk-averse bondholders rotating to stocks because everything is fixed and it seems better to buy something at its highs than its lows? or b) China is punishing us for the rare-metals challenge. We posit an alternative, less conspiracy-theory, less-conventional-wisdom (who is buying the Treasuries you are selling and who is selling the stocks you are buying reprise) perspective on the recent Treasury weakness. Its supply-and-demand stupid. The last few weeks have seen massive, record-breaking amounts of investment grade USD-based corporate bond issuance, at the same time dealer inventories for corporate bonds are at multi-year lows and Treasury holdings at all-time-highs. In general to underwrite the massive corporate bond issuance, dealers will place rate-locks (or short Treasuries/Swaps in various ways) to control the yield and sell the idea of the 'spread' to clients (which is where most real-money buyers will be focused on value. We suggest that the almost unprecedented corporate issuance and therefore need for rate-locks has provided a significant offer for Treasuries that the dealers (who are loaded) and the Fed (who is only minimally involved) was unable to suppress. The key question, going forward, is whether the expectations of a much lower issuance calendar will relieve this marginal offer in Treasuries and allow rates to revert back down?

Since the Greek PSI deal was announced early on Friday morning, European credit markets have been underperforming European equity markets quite materially. Friday in the US held up in a narrow range for a short-period but once we discovered that the CAC was in fact a credit event thanks to ISDA, the US credit market deteriorated rapidly and remains weak as US equity indices are holding stable. We wonder, with CBs seemingly on the sidelines for now and fall-out from the Greek deal remaining uncertain, whether credit is once again reflecting market angst more efficiently than the marginal robot in equity markets.

While everyone is focused on AAPL, or tech names, or energy sector growth, or multiple expansion as the driver of the next leg up in stocks, we take a slightly different tack. US equities are back above the highs of last year while US investment grade credit markets are still well below their best levels of last year. Until credit markets come along for the exuberant ride, and buy into the recovery/growth/no-tail-risk story we will not see a sustained rally (no matter how much fiat currency devaluation is undertaken) and as BARCAP notes today, there are 18 names that account for more than 50% of the discrepancy between equity's ebullience and credit curmudgeon-ness. Of these 18 names, 13 are financials (unsurprisingly) and indeed these are among the most liquid credits traded. So if you are bullish on a sustainable recovery, buying these credits seems the best high beta 'value' trade while bears should continue to watch the lack of confirmation of USD/fiat-numeraired equity market enthusiasm by risk-based credit markets.

ETF fund flows have been a uniformly positive source of capital into U.S. risk markets in 2012. Looking a little deeper at the decidedly 'risk-on' flows, Nic Colas (of Convergex Group) notes perhaps their most provocative feature has been their high degree of net concentration.  When you look at the entire “ETF Ecosystem” of listed funds, just 6 funds represent all the net gains in assets over the past month ($5.4 billion in net inflows) – LQD, HYG and JNK in fixed income, VWO in emerging markets, VXX in risk, and GLD in commodities. With 1,433 different ETFs listed on U.S. markets now, Colas likens the comprehension of the $1.2 trillion in AUM across these ETFs to how well you know your spouse as we know ETF flows are important (just like a wedding anniversary date or what day the trash is picked up at home) but with their still-evolving proliferation it seems a daunting task to keep tabs on them. All in all, this brief analysis points to more of a pause in investor sentiment rather than the opening for a more full-blown correction in the coming weeks.

The ever-so-popular high-yield bond ETF, HYG, is suffering its biggest 3-day drop since Thanksgiving as higher beta assets are underperforming and the up-in-quality and up-in-capital-structure trade gathers pace post LTRO 2. Even with last week's ex-divi date, we note that this loss of the last 2-3 days wipes out the yield that was 'reached for' of the last 2-3 months. It seems all too easy to buy high-yield bonds when they are on the rise but underlying that ETF is a portfolio of 'junk' assets - some better and some worse obviously - that are increasingly being driven top-down by the fast-money action in this newfound ETF's liquidity (as dealer inventories dwindle). This leaves them prone to just-as-fast exits as the secondary high yield bond market remains 'illiquid' away from benchmark size and ETF-bound assets providing little underlying 'pricing' evidence of market value. This is the largest underperformance of the high-yield market relative to the equity market since the recent rally began.

Blinded by the light of the European equity market, one could be forgiven for thinking that LTRO 2 has indeed had some stabilizing impact on the European (and even the world) economy market. However, just as we have been aggressively pointing out, this is not the case (or at least not a sustainable case) as we see the 'LTRO-stigma' rising - now 10-15bps wide of its post-LTRO best levels - as LTRO-behooven banks trade notably wider (worse) than non-LTRO-subservient banks. What is very clear is that European credit markets, which are now trading at their worst levels post LTRO are much more concerned at the unintended consequences of the massive subordination and dependency than the equity market appears to be. Senior financial credit spreads are underperforming as they re-price for the broad subordination that has occurred but investment grade and high-yield credit in Europe is dramatically wider today even as stocks levitate. With ECB deposits breaking records and bank funding costs rising (as opposed to the hoped for drop), it seems unlikely that all this freshly minted collateralized cash will find its way out to the real economy and do anything but further zombify European banks and implicitly drag economic growth down (as credit markets appear to be better at discounting once again). As Europe closes, credit is pushing even lower to its worst in over a week.

While everyone was busy ruminating on how little impact a Greek default would have on the global economy, the IIF - the syndicate of banks dedicated to the perpetuation of the status quo - was busy doing precisely the opposite. In a Confidential Staff Note that was making the rounds in the past 2 weeks titled "Implications of a Disorderly Greek Default and Euro Exit" the IIF was doing its best Hank Paulson imitation in an attempt to scare the Bejeezus out of potential hold outs everywhere, by "quantifying" the impact form a Greek failure. The end result: "It is difficult to add all these contingent liabilities up with any degree of precision, although it is hard to see how they would not exceed €1 trillion."  In other words, hold out at your own peril. Of course, what the IIF does not understand, is that for hedge funds it is precisely this kind of systemic nuisance value that makes holding out that much more valuable, as they understand all too well that they have all the cards on the table. And while a Greek default could be delayed even if full PSI was not attained by Thursday, it would simply make paying off the holdouts the cheapest cost strategy for the IIF, for Europe and for the world's banks. Unless of course, the IIF is bluffing, in which case the memorandum is not worth its weight in 2020 US Treasurys.

Here's concrete proof of a mass European bank run. If you missed it, don't worry - there'll be plenty more from where these came from...

After 22 crosses yesterday, and 12 more today, the Dow managed to close above 13000. Transports were lower but less so on Oil's modest retracement (though the Brent-WTI spread remained around $15). While stocks closed modestly higher, volatility and correlation markets remained considerably higher than would be expected and along with quite considerable relative weakness in HYG (the high yield bond ETF) into the close as well as a clear up-in-quality rotation was evident as investment grade credit outperformed notably (not exactly a high-beta risk-on shift). Apple's meteoric rise helped drag Tech to first place overall today and also YTD followed closely (YTD) by financials both up around 14%. The last week or so of slow bleed higher in stocks has notably not been led by a short-squeeze in general - based on our index of most shorted names - but as is becoming more and more clear, divergences (and canaries) are appearing all over the place but we suspect can be traced back to Apple in many cases for its over-weighting impact. Treasuries slid lower (higher in yield) after Europe's close but remain better on the week and modestly flatter across the curve. Aside from a hiccup around the macro data this morning, EUR pushed higher all day against the USD shifting into the green by the US close as JPY stabilized. The USD weakness helped Copper and Gold leak higher but Silver was the massive winner, now up an impressive 4.3% since Friday and 30% YTD as WTI lost $107 and is now down over 3% on the week. The IG rotation coupled with vol decompression makes some (nervous) sense heading into the LTRO results but it seems the new safe-haven trade is Apple (whose option prices are now the most complacent since early 2009).

NYSE volume was the 3rd lowest of the year so far (while ES was just below average) as stocks leaked lower all day to small net losses by the close. Financials led the drop in stocks as they start to catch up the credit market weakness we have been pointing to for over a week but while HY (the high yield credit spread index) continues to underperform (and stocks following at a lower beta), IG (investment grade credit spread index) modestly outperforms (the up-in-quality rotation) but HYG (the high-yield bond ETF) surged today into a world of its own once again. We suspect this is driven by 'arbitrage' flows between HY's recent richness and HYG's cheapness (as well as potential HY new issue impacts). Gold (and to a lesser extent Silver) was the story of the day as it exploded (perhaps on the Greek gold-collateral news) over $1780 intraday (now up over $55 in the last 3 days) although the USD did nothing (FX was quiet with JPY inching lower and EUR small higher as DXY leaked higher on the day to -0.25% on the week). The rest of the commodity complex jumped also (with WTI losing ground into the close even as Brent kept going - suggesting the spread decompression was in play). Treasuries rallied from early in the European day with yields dropping 6-8bps from the peaks and shifting the entire curve into the green for the week now (10y and 30Y around 1bps lower in yield). ES couldn't get significantly above VWAP today and CSFB's fear index (which tracks equity option skews) is at record highs which both suggest a preference to sell/cover is appearing (even as VIX diverged modestly from stocks today with implied correlation rising).

Volumes were below average but not dismally so as the sad 6.5pt drop in ES (the e-mini S&P 500 futures contract) from Sunday's open to today's close is incredibly the largest drop since 12/28 [correction: 2/10 saw a slightly larger open to close drop] on a day when the problems of Greece are now apparently behind us and Dow 13,000 means that retail will come storming back. High yield credit underperformed (and investment grade outperformed) as stocks drifted to Friday's lows suggesting some up-in-quality rotation (though HYG - the high-yield bond ETF - was strong most of the day). Financials ended the day red with the majors losing significant ground off intraday highs (and CDS widening still further) but the bigger story of the day was the rise in commodities with Copper (RRR cut?) and Silver outperforming (up 3.3% since Friday's close already), WTI managing $106 intraday and Gold touching $1760 (both up over 2% from Friday). What was surprising was the dramatic outperformance with the USD which weakened by 0.44% from Friday as EUR is up 0.75% from Friday alone (while Cable, JPY, and most notably for risk AUD are all weaker against the USD). Treasuries sold off through European hours today and then recovered about half the loss only to ebb quietly into the close with 30Y +6.5bps from Friday (another divergence with stocks) and steeper curve. All-in-all, it seems confusion reigned on Europe but the bias in credit (and financials) seemed more concerned than equities (even with HD and WMT) and FX as real assets were bought aggressively.