One of the less discussed topics by the propaganda machine is that with bond yields approaching record yields, and in the case of the 2Y below them, the S&P has no place trading over 1,000. There was a time when bonds and stocks would correlate, and as bond prices surged, equities would plunge and vice versa. Now that we live in HFT days where stock values are completely disconnected from fundamentals, and even the bond market, courtesy of the Fed's seemingly endless market interference, it makes sense to extrapolate what the fair value of stocks would be implied purely based on bond yields stripping away for the Fed. Attached we present a very simple regression analysis between simple 10 year spreads and the S&P, and the 2s10s (steepness between the 2 and 10 Year) and the S&P. What both analyses indicate is that stocks are approximately 30% overvalued, at least based on historical regression patterns relying on yields to imply stock prices. Yet even though this analysis is purely statistical, here is a simple extension: with US stocks at about $13 trillion in market cap, if one assumes the suggested 30% haircut the result is $9.1 trillion in fair market value. Considering that the Fed has pumped $2.5 trillion in the form of monetary stimulus, and Obama's various fiscal stimuli now amount to just over $1 trillion, that explains the delta. Bonds are implying where stocks should be almost to the dot, absent the $3.5 trillion pumped into stocks by the administration and the Chairman. Fair value of stocks, when stripped away from the printer and Congress, is 750.
Greece was the standout in Europe (and in fact across most sovereigns) with a 60bps decompression today (closing below 1000bps but managing to get above and trade handily upfront for much of the day). This is a 200bps decompression since the roll and while volumes remain marginal, bonds have weakened with the 2-5Y range inverting even more significantly. Calls for 50% haircuts on Greek sovereign debt in the stress tests, and an increasingly glib view of the effectiveness of the stress tests saw FINLs shift wider once again with SEN and SUB moving pretty much in line and notably FINLs and ExFINLs not decompressing. This is interesting as perhaps we are seeing the contagion leaking back into non FINLs (which would make sense via direct channel from lending/credit as well as indirect via austerity/growth slowing).
Two days ago, we posted a story titled "Why VaR Is A Joke: Morgan Stanley Admits Losses in April And May Were "Much Higher" Than Anticipated" in which we extracted a segment from a report by Jim Caron to claim that VaR models are broken beyond fixing. Today, Morgan Stanley has asked us to provide a clarification on our post. We gladly comply.
The comments from Jim Caron that you reference in this article concern a model portfolio maintained by Morgan Stanley Research. This fact isn't clearly reflected in the headline or in the article. The headline in particular suggests that the Firm is disclosing losses. This is not the case. Again, Caron's comments concern a model portfolio within Morgan Stanley Research. Please let me know if you can clarify this in an update, and let me know if you have any questions.
Morgan Stanley | Corporate Communications
We hope this clarifies everything.
Stress in the Spanish banking system is nothing new but with DS-K swooping in this week from the IMF, and the oh-so-trustworthy Stress-Tests due to be announced, anxiety was running high as Spain sovereign risk broke back above 250bps and BBVA and Santander struggled wider and flattened (CEE sovereigns also floundered today). Of course, far more importantly, World Cup favorites Spain lost their first round football match to the Swiss 1-0 (shame I hear you all cry).
George Osborne, the UK's Chancellor of the Exchequer, a role equivalent to that of Tim Geithner in the US, at least in public office, not sure about tax "avoidance", has just announced the abolition of the FSA - the English just as worthless equivalent to the SEC. It is time Mary Schapiro's corrupt organization share the same fate. From the FT: "George Osborne moved to redress what he described as the spectacular regulatory failure of the City, announcing the abolition of the Financial Services Authority and a sweeping increase in the Bank of England’s powers." And in other news, UK's Bernanke-equivalent will now double up as uber regulator and Viceroy of the West Indies, due to amazing new powers given to him by the Osbourne super mushroom: "Mervyn King, the Bank’s governor, will become one of the most powerful central bankers in the world, with a new remit to prevent the build-up of risk in the financial system in addition to his monetary policy role." In other words, one big step forward, and an infinite number of steps back. After all why bother with petty theft, when the Central Banks will soon be funneling trillions away from what's left of the global middle class, perfectly legally, in broad daylight, and at record 2s10s.
Spreads were mixed this week with indices modestly tighter but intrinsics notable wider as our view of the overlay unwinds into idiosyncratic derisking appears to be playing out in cash and synthetic credit. Europe outperformed US this week with help broadly from FINLs and Sovereigns but the same theme of underlying name underperformance against index outperformance was evident everywhere (especially at the HY/XOver end of the credit spectrum). Watch this week for further bond underperformance and/or skew compression - there is much more going on down here in the weeds than is evident at the aggregate levels and we suspect sooner rather than later this sentiment will spread back up to the indices (and the realities of short- and longer-term funding markets).
Bottom line - while a 3% rally in stocks and the best performance day in IG and HY credit since 5/27 hide what we think is going on under the covers. Breadth was much more mixed in single-names and the unwinding of index overlays and single-name longs (bonds or CDS) that was evident today seem to signal a risk-off sentiment from the top-down (with technicals dominating index moves today). The increasing correlation (and again we are careful to avoid using the term dependence) between stocks, credit indices, and carry currency crosses appears to be getting tighter (with EURJPY and ES_F hardly leaving each other's side today) but for the third day in a row, stocks have outperformed credit.
IG is at its widest (on-the-run adjusted) since 5/28/09 today (and we note that the last time IG was here, HY was over 1000bps) - but different portfolios make the comps a little tricky. Across the broad universe of credit, 5Y was pretty much unch on aggregate as 3Y underperformed with APC, RIG, and HAL the worst performers on a DV01-adjusted basis (along with UAL and CONTI). No clear ratings-related theme today as cohorts were very mixed as we saw bond volumes low once again but underperforming where we did see them (smells like Monty Python's Holy Grail - investors bringing out the dead as markets show any appetite for risk). FINLs and Energy were the worst performing sectors by far today with Utilities and Capital Goods the best performers. One day to go til the greatest sporting event in the world (aside from my eldest daughter's U10 Soccer matches) and we have started to prepare ourselves - bets placed (in my home country of course or that would be illegal) and Fantasy Squad selected. Ennngggeeerrrrlaaannnddd.
The most recent "it's time for risk on" note from Morgan Stanley is pure comedy defined. Jim Caron is now openly fishing to try to get any last remaining greater fools into the HFT shark infested swimming pool. The punchline: "front-end risk metrics remain stable, as 3m Libor sets slightly higher at 0.537, which is actually lower than was expected on Friday. Tactically, as a result, I think the time is ripe to put on risk right now." The salvage attempts by the TBTFs are becoming a surreal Lewis Black skit. Oh well, one always needs to goal seek "better then worst case data" to fit with the imminent risk on reversal. Looks like gold longs got the memo and saw right through it.
As a reminder, for anyone considering this a buying opportunity (other than for a swing trade) based on rebalancing or mean-reversion should note two things: fund outflows are picking up for risk assets, and, even more importantly in our view, risk budgets will mean that allocations will be materially lower (in their wondrously pro-cyclical manner) as we note IG's three-month realized vol is its highest since NOV08 and HY's three-month realized vol is its highest since OCT07 (higher still if we adjust for intraday vol)!
All-in-all a very weak close to a worrisome day (especially given month-start rebalancing hopes). Even the positive ECO prints were questionable on the basis of regime-change a month ago and anything more recent was showing a disappointing trajectory. Weakness was evident across all sectors and industries in credit but the stress in the ENRG space are clearly particularly notable (especially given their somewhat safe-haven status that may have hurt so many recently). Levels to consider in IG are 109.5bps as next support with 118.75bps as a decent short-term pivot. HY held above its pivot of 645bps today with next stop 587bps (large range due to recent vol) and a target of 702bps in the short-term.
The EURJPY has now pushed back below the 110 support even as stocks, which nobody except a few computers, trades any more, fight tooth and nail to give the impression there is buying interest. Hopefully, readers have been prudent enough to stay out of the market since when it broke down terminally, some time in April of 2009, and ridiculous equity moves such as today's will not matter. What should matter, is the ongoing flatenning in the 2s10s, which, as we have claimed previously, is a far more troubling phenomenon, and indicates that between the unending FX carry unwinds, and the Treasury steepener selloffs, liquidations are continuing. That these are not spilling over into the now completely irrelevant stock class is not at all important: stocks are now just for administrative window dressing, and to push the Obama propaganda just how good the economy is, which as everyone knows, is nothing but a lie.
The most ominous sign for US bank P&L continues to not relent: the 2s10s curve, which is the primary source of "revenue" for the hedge funds formerly known as US banks until a bunch of idiots came along and repealed Glass-Steagall, has just gone inside 240 bps. As before, we view this as the primary margin call threat, as billions, if not trillions, of wrong-way bets on curve steepening move further out of the money with every passing basis point. Once the first major repo counterparty blinks and demands a trand unwind, this trade will snap and we could see an even faster flattening, which would lead to some scary consequences for every other asset class.
Spreads closed the day weaker after clinging to gains until mid-afternoon and outperforming stocks. A slow-and steady decline in FINLs finally cracked the low activity rally in risk assets but we note IG underperformed HY as stocks sold off helped by the EUR stalling. Cash underperformed synthetic single-name credit once again but the late-day rush for protection suggests investors once again covering with macro overlays - not a good sign for bonds.
On Friday we pointed out that after nearly 9 months of straight line steepening, the Treasury curve, as depicted by the spot 2s10s, has collapsed, and has flattened from 290 to 240 bps practically overnight, in what has been an unprecedentedly rapid move in the curve, driven primarily by asset liquidations. Those with exposure to spot are panicking, and have been forced to cover what amounts to billions in levered notional positions. Some (the lucky ones) only have synthetic exposure, via Constant Maturity Swaps or other Robertson/Klarman-esque contraptions, thus limiting a downside they can walk away from. They are the minority. Yet an interesting observation, coming by way of Morgan Stanley's Jim Caron, who little by little is forced to wave the white flag of surrender not only on his 5.5% call in the 10 year by Year End, but also on his all out steepening trade, is that flattening has really only occurred in the spot curve: forward yield curves, both the 1y and 2y, have surprisingly retained their steepening bias in spite of unprecedented vol and liquidations. Why is this? Caron explains. However, more relevantly, his observation that a convergence between spot and forward curves is imminent could serve as an easy (famous last words) way to pick 100 bps.