Investment Grade

Highly paid shills for the status quo on Wall Street have recently been wheeled out to observe the fundamental ugliness of western government bonds. They are correct. This is an asset class that has managed to defy the laws of economics in becoming ever more expensive even as its supply swells. Their response has been to recommend piling into stocks instead. The logic here is not so pristine. If Napier's thesis is correct, the West faces a period of outright deflation, which will be deeply traumatic for exactly the sort of speculative stocks that have lately done so well. Admittedly, the picture is confused, and prone to all sorts of political horseplay, as observers of the long-running euro zone farce can attest. Nevertheless, when faced with a) huge underlying uncertainties; b) structurally unsound banking and government finances; and c) central banks determinedly priming the monetary pumps, we conclude that the last free lunch in investment markets remains diversification. G7 government bond markets are a waste of time (though you may end up being cattle-prodded into them regardless). But there are still investment grade sovereign markets offering positive real yields. Stock markets are partying like 1999. Which, in many cases, it probably is. We would normally advise to enjoy the party but dance near the door.

A lesson to be learnt from the individuals who continue to buy European Debt

While Greece and Europe continue sinking ever deeper into the colonial quicksand of Pax Goldmania, Iceland, which blew up, pushed its banks into bankruptcy, and arrested its corrupt bankers, is well on its way to being the world's only normal country.

• ICELAND RATINGS RAISED TO INVESTMENT GRADE BY FITCH
• FITCH UPGRADES ICELAND TO 'BBB-'; STABLE OUTLOOK
• FITCH DOES NOT EXPECT ICELAND TO SLIP BACK INTO RECESSION
• FITCH SAYS ICELAND GOVERNMENT DEBT PEAKED AT 100% OF GDP IN '11

Too bad the Goldman colony of Greece (and soon everyone else - thank you first lien "bailout" debt) will not see headlines such as these written about it any time in the next century.

Financial credits remain the big underperformer hinting at much less risk appetite than USD-based stocks would indicate for now but broad risk assets staged an impressive bounce recovery on better than average volumes today as early weakness in Europe was shrugged off with better-than-expected macro data in the US (claims and Philly Fed headlines) and then later in the morning the story in the ECB Greek debt swap deal. We discussed both the macro data and the debt swap deal realities but the coincident timing of the ECB story right into the European close (when we have tended to see trends reverse in EUR and risk anyway) helped lift all risky asset boats as USD lost ground. The long-weekend and OPEX tomorrow likely helped exaggerate the trend back today but we note HYG underperformed out of the gate and while credit and stocks did rally together, the afternoon in the US saw stocks limp higher on lagging volumes (and lower trade size) as credit leaked lower. Treasuries sold off reasonably well as risk buyers came back (around 8bps off their low yields of the day pre-ECO) but rallied midly into the close (as credit derisked). Commodities all surged nicely from the macro break point this morning with Copper best on the day but WTI still best on the week. Silver is synced with USD strength still (-0.25% on the week) as Gold is modestly in the money at 1728 (+0.4% on the week) against +0.47% gains for the USD still. FX markets abruptly reversed yesterday's USD gains with most majors getting back to yesterday's highs. GBP outperformed today (at highs of the week) and JPY underperformed (lows of the week). VIX shifts into OPEX are always squirly and today was no different but we did see VIX futures rise into the close. We wonder if the last couple of days of Dow swings and vol spikes and recoveries will remind anyone of the mid-summer day swings last year?

Now everybody's bank bashing, of course the reason to bash the banks is 4 years old, despite Bove-like analysis to the contrary. I will discuss this on CNBC for a FULL HOUR tomorrow from 12 pm to 1pm.

The good people at Knight put together a comprehensive list of potential ratings for banks in Europe after Moody's came out with their outlooks. We agree that banks getting shifted to non-investment grade is a big deal.  We saw the impact for Portugal once it got taken out of the indices, and we think for banks it will be an even bigger deal to lose that investment grade status.  Sure, they can still go to the LTRO, but it is hard to function as anything other than a zombie bank once you lose that rating...

As AAPL dominates the headlines for its dramatic 5% reversal intraday and biggest drop in over two months, perhaps it is worth pointing out that the lacking volumes have returned with a flourish. ES (the e-mini S&P futures contract) saw its heaviest volume since this mid-December rally began (30% above average) as our recent pontification on the messages from the credit market (along with the rhythmic periodicity of the rally's size and length) may be starting to wear on investors' risk appetites. After European credit markets accelerated to the downside today, US investment grade and high-yield credit was not buying any of the overnight rally in stock futures and moved wide of yesterday's pre-Samaras rally out of the gate. Stocks surged upwards, tracking uber-stock AAPL but as chatter of a NASDAQ rebalance sent game-theorists scrambling to migrate, AAPL's slump dragged everything down (sadly) with ES stalling at the pre-China rumor level before falling to pre-Samaras levels from yesterday's lows. A lack of rumors and no QE mention from FOMC minutes along with lackluster news from the Eurogroup did nothing to rescue the situation as EURUSD ended on its lows (-1% on the week now) and USD Strength saw carry trades dragging stocks down. Interestingly, post-FOMC Treasuries came off their best levels in the afternoon (even as stocks were tanking) but we saw Gold rallying (in the face of a stronger USD) - does make one wonder on where the safety trade is now. WTI closed near its highs of the day (over $102) and as we noted earlier Brent in EUR closed at record highs as Copper is -1.3% on the week and Silver is tracking USD -0.75% or so on the week.

European (like US) stocks remain in a narrow range just above the cliff of the unbelievably good NFP print of 2/3. US and European credit markets have lost significant ground since then and it seems equity investors just want to ignore this 'uglier' reality for now. The BE500 (Bloomberg's broad European equity index) is unchanged from immediately after the NFP 'jump', investment grade credit is +10bps from its post-NFP tights, crossover (or high yield) credit is around 50bps wider, Subordinated financial credit is +50bps off its post-NFP wides at 382bps, and senior financial credit is an incredible 36bps wider at 225bps (by far the largest on a beta adjusted basis). The divergence is very large, increasing, and a week old now and perhaps most importantly as we look forward to LTRO Part Deux, LTRO-ridden banks have underperformed dramatically (40bps wider since 2/7 as opposed to non-LTRO banks which are only 10bps wider) - how's that for a Stigma? Some 'banks' have suggested the underperformance of credit is due to 'technicals' from profit-taking in the CDS market - perhaps they should reflect on why there is profit-taking as opposed to relying on recency bias to maintain their bullish and self-interest positioning as the clear message across all of the credit asset class is - all is not well.

Since last Wednesday, European financials have seen credit spreads widen dramatically. After some initial gains today, they once again retreated and traded out to their widest levels in two weeks as both financials and non-financials closed wider and at their worst levels of the day in European credit. Sovereigns also deteriorated significantly after around 8amET with 10Y BTPs for instance adding 20bps or so to close unch (as the rest of the major sovereigns saw de minimus +2 to -4bps changes). Bunds and Treasuries stayed close together and we note TSYs rallied 7bps (from +4 to -3bps) from early morning Europe trading and leaked off a little into the close. WTI is holding above $100 even as Copper is down 1% while Gold and Silver's gains are in sync with USD's modest losses - though EUR is leaking back lower (holding just above 1.32) into the close to around unch. While this post-Thanksgiving Day rally was perhaps predicated on global growth (US decoupling, China soft landing) and extended by LTRO (contagious bank insolvency runs risk containment), the underperformance of banks' credit risk in the last few days should be very worrisome with Senior unsecured credit wider by over 30bps in 3 days, its largest deterioration in two months.

We have been warning of the bearish divergence in European credit markets all week and today saw that trend continue as the best-performers of the year-to-date become the biggest losers on the week. Financials and high-yield (crossover) credit have dramatically underperformed this week (with XOver +50bps touching 600bps once again) as credit overall trades considerably wider than before the NFP-print jump. Investment grade is wider but diverging a little today as decompression trades are laid back out and up-in-quality trades are reconsidered - and away from financials which have seen their senior unsecured credit spreads jump from under 190bps to almost 220bps on the week. Broad equity markets in Europe also saw their worst week of the year but are lagging the credit sell-off for now and sit (for context) right around the pre-NFP jump levels. Sovereigns were mixed on the week with the last couple of days seeing notable deterioration. Spanish spreads are +33bps, Italian spreads are -9bps on the week but are 25-30bps off their tights but it appears Portugal was the darling of the ECB this week as it managed an impressive 100bps compression (10Y now almost 500bps off its wides on 1/30) but this impressive tightening only gets the peripheral nation back to 1050bps (and mid-January levels - still triple the level of risk of a year ago).

Credit markets are continuing the trend of the last couple of days with this afternoon seeing their underperformance accelerating. Major underperformance this week in investment grade and high yield credit markets relative to stocks (and as we noted this morning, we are also seeing financial credit in Europe notably underperforming) as Maiden Lane II assets are sold and high yield issuance peaks (and liquidity dries up). Adding to the concerns, VIX futures saw their biggest 2-day jump in over two months despite equity's modest rally. On a day when Pisani tells us there was much to rejoice about, stocks managed only negligible gains (even with broad risk assets in risk-on mode, TSY yields up, FX carry up, Oil up) and while stocks are limping higher now (aside from AAPL of course) with financials underperforming, perhaps this week of notably higher average trade size in equity futures is the calm before the real storm gets going - as credit and vol seems to be hinting at.

Somehow, once again, we managed to rally EURUSD (to 2 month highs) on the back of Greek deal hopes (even as Merkel stomped her feet, Hollande flexed his muscles, and Dallara/Venizelos had nothing to report) which maintained a modicum of support for equity markets (which also got a little late day push from another record-breaking Consumer-Credit expansion) as cash S&P made it to early July 2011 levels. Unfortunately, with Utilities leading S&P sectors, credit diverging wider in investment grade and high-yield, Copper underperforming (post overnight China reality checks), WTI's exuberance (relative to Brent at least), and implied correlation diverging bearishly from VIX, we can't say this was a wholly supported rally. Broad risk-asset proxy (CONTEXT) did stay in sync with ES (the e-mini S&P 500 futures contract) after the European close as Treasuries held up near the day's high yields and FX carry stabilized. Financials lagged with the majors actually underperforming for a change as we note the late-day surge in ES to new highs saw significant average trade size suggesting more professionals covering longs into strength rather than adding at the top. Volume was above yesterday's dismal performance but remained below the year's average so far. Credit and equity vol are back in line and credit has now been flat and underperforming for the last three days (even as HY issuance has been high).

The Fed is doing everything it can to push people out the risk curve, and in particular is encouraging the hunt for yield in credit products. A lot of people are arguing that “credit” is cheap.  That spreads are high and offer a lot of value.  That may even be true, but the problem is that most retail investors don’t own bonds on a spread basis, they own them on a yield basis. The ETFs are all yield based.  The mutual funds are all yield based.  The argument might be that “corporate credit spreads” are cheap, but people aren’t investing in corporate credit spreads, they are investing in corporate credit yields, and that strikes me as very dangerous. The yields are being held down by operation twist.  The treasury has anchored the short end and continues to shift money to the long end, keeping those yields low, for now.  What happens when that ends? And keep in mind that credit almost always grinds tighter and gaps wider with little to no warning.  When the shift from concern about not getting enough yield to concern about how much notional I can lose always seems to catch the market by surprise.

While the EURUSD's recovery post Europe's close seemed to modestly support stocks, the USD is still up from Friday's close as ES (the e-mini S&P 500 futures contract) closes marginally in the green against the direction of FX carry, Treasuries, commodities broadly, and credit. The volumeless (and gravitationally unchallenged) push from post-Europe dip lows this afternoon were generally ignored by VIX, investment grade, and high-yield credit markets, after the morning was a relatively significant amount of selling pressure in HYG (the increasingly significant high-yield bond ETF) to pre-NFP levels only be bough all the way back and some more into the close. Average trade size and deltas had a decidedly negative feel on every algo-driven push higher from VWAP to unchanged but the divergence between Brent and WTI dragged the Energy sector over 1% higher (as every other sector lost ground with Financials and Materials underperforming. Treasuries rallied well from the Europe close and closed just off low yields of the day as commodities all ended lower from Friday's close with Copper and WTI underperforming and Silver just edging Gold as they hovered around USD's beta for the day. VIX dropped modestly after the cash close but ended higher on the day with a notably low volatility of vol from mid-morning onwards (and the late-day vol compression seemed index-driven as implied correlation also fell commensurately). A quiet day in European sovereign and financials along with the disastrously low volume day in ES and on the NYSE really don't feel like signs of broad participation as Greek events slowly but surely unfold along the path of known resistance.

Equity and credit markets eked out small gains on the day as Treasuries limped a few bps lower in yield (with 30Y the notable underperformer) and the EUR lost some ground to the USD. ES (the e-mini S&P futures contract) saw its lowest volume of the year today at 1.35mm contracts (30% below its 50DMA) as NYSE volumes -10% from yesterday but average for the month. Another small range day in almost every market aside from commodities which saw significant divergence with Silver (best today) and Gold surging (up around 1.15% on the week) while Oil and Copper dived (down 2.6-3% or so on the week) with the former managing to scramble back above $96 into the close. ES and the broad risk proxy CONTEXT maintained their very high correlation as Oil and 2s10s30s compression dragged on ES but AUDJPY and TSYs post-Europe inching higher in yields helped ES. HYG underperformed all day (often a canary but we have killed so many canaries recently). Energy names outperformed on the day (as Brent and WTI diverged notably) but financials did well with the majors now back up to the late October (Greek PSI deal) highs. All-in-all, eerily quiet ahead of NFP but it feels like something is stirring under the covers as European exuberance didn't carry through over here (except in ZNGA and FFN!).