High Yield

While the supposed common-knowledge is that rising short-interest is where to look for epic squeezes (and indeed it appears to the case in individual stocks); in ETF-land, it tends to be the opposite (especially when the underlying of the ETF is relatively illiquid). Absolute short interest in the high-yield bond ETF HYG is at a record - surging to over 23mm shares - heralded by many as evidence that HY can squeeze higher. However, given the incredible rise in shares outstanding in HYG (as flows drove creation until around six months ago) the more reliable indication is the short-interest-ratio. The SI ratio is back at the same levels it was at the highs of the Oct 2007 period - we humbly suggest that this (as was clear in 2007) is anything but contrarian as professional bond managers using ETF liquidity to hedge their over-stuffed and over-flowing illiquid HY bond portfolios. With HY 'yields' at record lows, HY spreads near record lows (and crossover having only been tighter during 1946-65 repression), leverage rising notably, and valuations extreme (only 22% of CCC credits priced with yields over 10%!!!) is it any wonder that the professionals are as confidently hedged as they were as the credit crisis exploded and Lehman struck.

Not even the Fed pre-monetizing yesterday of today's 30 Year reopening auction could do much to improve demand for today's $13 billion sale in long-dated paper. Because if yesterday's 10 Year auction was a testament to demand from Direct and Indirect buyers, today's final auction of the week was anything but. Moments ago the Treasury sold $13 billion in 30 year paper, in a 29 year, 11 month reopening, of the infamous 912810QZ4 Cusip, and which priced at a high yield of 3.248%, the highest yield since last March's 3.381%, and more importantly 1.5 bps higher than the When Issued 3.233%. The internals explained why the demand in the primary market was just not there: Indirects got 42%, Dealer take down was 51.2%, which mean Direct bidders were allotted just 4.9% of the total. This was the lowest Direct allocation since September of 2009, and in stark contrast to yesterday's surge in 10 Year Direct bidders. Finally, the Bid to Cover came at 2.43, the lowest since August of 2012.

It seems more likely to Morgan Stanley's Gerard Minack that central bankers may win the battle: sustaining recovery in developed economies with extraordinarily loose monetary policy. For a while this would go hand-in-hand with better equity performance. The battle is against a crisis caused by too loose monetary policy, elevated debt and mis-priced risk. Ironically, he notes, central bankers may overcome these problems by running even looser monetary policy, encouraging a new round of levering up, and fresh mis-pricing of risk. However, winning the battle isn't winning the war. If central bankers do win this round, the next downturn could be, in Minack's view, an omnishambles. In short, it seems more likely that central bankers may add another leg to the credit super-cycle. The key question for investors in this scenario is when (and how) this cycle may end, and Minack's hunch is that this cycle is already closer to 2006 than 2003.

This is the third day in a row that an attempt to mount an overnight ramp out of the US has fizzled, with first the Nikkei closing down for the second day in a row and snapping a week-long rally, and then the Shanghai Composite following suit with its 5th consecutive drop in a row as the rumblings out of the PBOC on the inflation front get louder and louder, following PBOC governor Zhou's statement that inflation expectations must be stabilized and that great importance must be attached to inflation. Stirring the pot further was SAFE chief Yi Gang who joined the Chinese chorus warning against a currency war, by saying the G20 should avoid competitive currency devaluations. Obviously China is on the edge, and only the US stock market is completely oblivious that the marginal economy may soon force itself to enter outright contraction to offset the G-7 exported hot money keeping China's real estate beyond bubbly. Finally, SocGen released a note last night title "A strong case for easing Korean monetary policy" which confirms that it is only a brief matter of time before the Asian currency war goes thermonuclear. Moving to Europe, it should surprise nobody that the only key data point, Eurozone Industrial Production for January missed badly, printing at -0.4% on expectations of a -0.1% contraction, down from a 0.9% revised print in December as the European recession shows no signs of abating. So while the rest of the world did bad or worse than expected for the third day in a row, it will be up to the POMO and seasonally adjusted retail sales data in the US to offset the ongoing global contraction, and to send the perfectly manipulated Dow Jones to yet another all time high, in direct refutation of logic and every previous market reality ever.

We are wondering if and when these signals will have significance.

SYFMUDD

The same pattern we have seen every day for the past week is back - slow overnight levitation as bad news piles on more bad news. What bad news? First as noted earlier, a collapse in Chinese imports and a surge in exports, which as SocGen explained is a harbinger of economic weakness in the months to follow, leading to yet another negative close for the Shanghai Composite. Then we got the UK January construction data which plunged by 7.9% according to ONS data. Then the Bank of Italy disclosed that small business lending was down 2.8% in January. We also got a negative Austrian Q4 GDP print.  We also got Spanish industrial output plunging 5% in January (but "much better" than the downward revised -7.1% collapse in December). Capping the morning session was German Industrial Production which not unexpectedly missed expectations of a 0.4% increase, printing at 0.0%, although somewhat better than the horrifying Factory Orders print would have implied. Finally, the ECB announced that a total of EUR4.2 billion in LTRO 1+2 will be repaid in the coming week by 8 and 27 counterparties, about half of the expected, and throwing a monkey wrench in Draghi's narrative that banks are repaying LTRO because they feel much stronger.  Yet none of this matters for two reasons: i) the Japanese Yen is back in its role as a carry funding currency, and was last trading at 95.77, the highest in four years, and with Jen shorts now used to fund USD purchases, the levitation in the stock futures was directly in line with the overnight rout in the Yen; and ii) the buying spree in Spanish bonds, with the 10 Year sliding overnight to just 4.82%, the lowest since 2010.

What really strikes us is the universal belief by the majority of analysts, economists and commentators, that there is currently "no evidence" of an asset bubble.  This idea was further confirmed by Bernanke's testimony last week he explicitly stated: "I don't see much evidence of an equity bubble" In the long term it will ultimately be the fundamentals that drive the markets.  Currently, the deterioration in the growth rate of earnings, and economic strength, are not supportive of the speculative rise in asset prices or leverage.  The idea of whether, or not, the Federal Reserve, along with virtually every other central bank in the world, are inflating the next asset bubble is of significant importance to investors who can ill afford to once again lose a large chunk of their net worth. It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: "Stocks have now reached a permanently high plateau."  The clamoring of voices that the bull market is just beginning is telling much the same story.  History is repleat with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.

The underlying question in Bill Gross' latest monthly letter, built around Jeremy Stein's (in)famous speech earlier this month, is the following: "How do we know when irrational exuberance has unduly escalated asset values?" He then proceeds to provide a very politically correct answer, which is to be expected for the manager of the world's largest bond fund. Our answer is simpler: We know there is an irrational exuberance asset bubble, because the Fed is still in existence. Far simpler.

There was nothing notable about today's just concluded $35 billion 5 year auction, with the possible exception of the fact that at a high yield of 0.777% (of which just 12.5% was allotted at the high), just inside the When Issued 0.778% at 1 pm, this was the first yield drop in three months, breaking the sequence of rising yields since December 2012 when Bernanke announced his $1 trillion balance sheet expansion program for 2013. Aside from that, the Bid to Cover of 2.85 was just shy of January's 2.88, and on top of the TTM average of 2.86. The Direct takedown was a weakish 14.3%, the lowest since September 2012, Indirects saw a 41.7% allocation, the highest since November, and the remainder was given to the Dealers, who will as usual promptly flip their quota back to the Fed while picking up several point in margin spread at the upcoming POMOs. Overall a snoozer, which however with tomorrow's last auction for this week, will take total record US debt which was $16.61 trillion higher by $53 billion to $16.7 trillion, or a 105% debt/GDP rounded up.

This coming from the guy who a month ago called for "Dow 20,000", all we can say is... #Ref!

Please do not adjust your monitors: that strange, non-green color greeting you this morning is not a "glitch." Following yesterday's market drubbing, in which a modest 1% decline in the S&P ended up being the biggest market drop of 2013, we next got a wipe out in China, where the SHCOMP plunged by 3% the most in 15 months, down the third day out of four since the start of the year of the Snake on renewed concerns around home purchase restrictions urged by the government, but mostly driven by rampant liquidations of commodity-related stocks following yet another liquidity withdrawing repo (not reverse) by the PBOC which took out even more money out of the market. We then continued to Europe where despite the near-record surge in German optimism (because in the New Normal hope is a strategy - the only strategy), German manufacturing PMI missed expectations of a rise to 50.5 from 49.8, instead printing at 50.1, while the Services PMI outright declined from 55.7 to 54.1 (55.5 expected).  We wonder how much higher this latest economic disappointment will push German investor confidence. Not too unexpectedly, Europe's suddenly weakest economy France also disappointed with its Mfg PMI missing as well, rising from 42.9 to 43.6, on expectations of a 43.8 print, while Services PMI declined from 43.6 to 42.7, on "hopes" of a rise to 44.5. The result was a miss in Europe's composite PMIs with the Manufacturing posting at 47.8 on expectations of 48.5, while the Services PMI was 47.3, with 49.0 expected, and a blended PMI missing just as much, or 47.3 with 49.0 expected, and down from 48.6. The news, which finally reasserted reality over hopium, immediately pushed the EURUSD to under 1.32, the lowest print since January 10. Therefore while Germany may or may not escape recession in Q1, depending on how aggressively they fudge their export numbers, for France it seems all hope is now lost.

While most mainstream market watchers will pontificate wildly on the VIX as indicative of whatever their whimsy of the day tends to be, we prefer to look at relative performance. The forward-looking implied vol is currently only just below its multi-year average premium to realized volatility (so a low VIX is not that exciting standalone). Realized volatility is pretty much as low as it has been in the last four years, courtesy of the Fed - and each time has been followed by a resurgence soon after. However, there is one more indicator of potential over-exuberance that offers some hope for traders - the spread between SPY (S&P 500) implied vol and HYG (high yield debt) implied vol is at its lowest since the crisis - and each of the previous four times this spread has been this narrow, we have seen notable weakness in stocks soon after. With HYG so 'cheap' to stocks, it seems being long HYG vs. short SPY, or long SPY vol vs. short HYG vol makes some sense for some low vol cheap protection.

In the aftermath of yesterday's surge in German hopium measured by the ZEW Economic Survey which took out all expectations to the upside, it was inevitable that the other double-dipping country, France, telegraphed some optimism despite a contracting economy and would follow suit with a big  confidence beat, and sure enough the French INSEE reported that February business sentiment rose from 87 to 90, on expectations of an unchanged number. And the subsequent prompt smash of investor expectations in Switzerland, where the ZEW soared from -6.9 to +10.0 tells us that something is very wrong in the Alpine country if it too is trying so hard to distract from the here and now. And while one can manipulate future optimism metrics to infinity, it is reality that is proving far more troublesome for Europe, as could be seen by the Italian Industrial Orders print which crashed -15.3% Y/Y on expectations of a smooth -9.5% drop, down from -6.7% previously. Since industrial orders are a proxy for future demand, a critical issue as Italy enters 2013 after six consecutive quarters of economic contraction and with no relief on the horizon, it is only fitting that Italy should shock the world with an off the chart confidence beat next.

The quiet overnight session was started by comments from Buba's Weidmann, whose statement, among others, that the ECB will not cut interest rates just to weaken the EUR together with the assertion that the EUR is not seriously overvalued, sent the EURUSD briefly higher in pre-European open trading. Of secondary importance was his "hope" that the ECB will not have to buy bonds (it will once the market gets tired of Draghi open-ended verbal intervention), something he himself admitted when he said the ECB "may be forced to show its hand on OMT." The stronger EUR did not last long, and in a peculiar reversal from prior weeks when the European open led to a spike in the cross, saw the EURUSD dip to three week lows, touching on 1.3310, before modestly rebounding. This validity of the drop was confirmed two hours later when in the first key economic datapoint, it was revealed the Euroearea exports fell 1.8% in December, the most in five months. As SocGen said "the monthly trade data rounded off what has undoubtedly been a pretty dismal quarter for the euro area. Overall euro area exports fell by 1.8% m/m in December although this was offset by a even bigger 3% decline in imports - which itself reflects the weakness of domestic demand in some euro area countries. Maybe of more interest is the latest data on the destination of euro exports. These continue to show a pronounced weakness in global demand (albeit for November). This indicates that weakness in Q4 is not solely a domestic affair but also reflects a wider slowdown in the global economy."

Many were looking at today's $16 billion 30 Year bond auction to see if the same weakness that was exhibited by yesterday's tailing 10 Year would repeat. This did not happen, and in fact today's auction, concluding this week's offering of paper, was probably the tamest of the lot. With a When Issued trading at some 3.185% at 1 pm, the high yield of the auction came inside the WI, at 3.18% with 85.2% allotted at the high. The Bid To Cover also did not indicate any particular weakness, as the 2.74 B/C, just a fraction below January's 2.77, was well above the 12 month trailing average of 2.61. More importantly, unlike the Indirect weakness seen in this week's prior auctions, Indirects took down 36.4% of the offering: nothing to write home about, but also better than the 12 TTM of 34%. Directs were responsible for 14.5%, which left 51.2% for the dealer. Finally, while the pricing yield was the highest since the 3.23% seen in April of 2012, at this point what happens at the long end is largely meaningless, as the marginal buyer is virtually non-existent. Recall that as the Treasury itself said, "In Feb 2013, Fed Will Buy 75% Of New 30y Treasury Supply." And that is all that matters to quell concerns of any great rotation in or out of bonds.