Bank Bonds Not Buying The Rally

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.  


The biggest divergence (and rather surprising on such an apparently risk-on mode day) was US financials. While stocks managed to recover from earlier losses as the broad market levitated on weaker and weaker volumes as the day wore on, credit spreads for the major financials remained wide - worryingly wide.

There are some reasons for this divergence being bandied around by sell-side shops - varying from 'normal profit-taking' to 'its a skew thing - bonds haven't confirmed the CDS move'. We remember back to last Q1/Q2 when every bond manager and his mum were filled to the gills with senior financial paper (juicy yield, TBTF etc) and the same kind of arguments were mentioned then when CDS started to leak wider. We all know how that ended.


We suspect that this decompression (or worsening) in CDS spreads for the major US financials (and remember we have been creaming about the weakness in European banks for two weeks now) is due to the ease of use of CDS specifically as a hedge tool (i.e. easier to buy protection than sell your bonds into an illiquid market and trigger more selling), there is likely a systemic risk effect from the lack of a firewall surrounding Europe still that is rising due to the pending hard default that is so obviously going to occur in Greece, and dealer inventories are at multi-year lows (blame Dodd-Frank or Volcker) meaning little ability to provide borrow (less likely) or soak up risk without offsetting through CDS




We also wonder if the Maiden Lane II sales last week (and a week or two back) have soaked up some balance sheet (or more likely brought out some liquidity-seeking systemic hedgers as the deal likely went off below market given that GS kept it on their books). A quick look at CMBX prices shows that they have stopped benefiting from the post-Thanksgiving Day printfest and most have been falling for a month or so. AAA has been rallying for no other reason (in our simple minds) than the market is becoming increaisngly bereft of AAA collateral (but that's another story).



Either way - we know there is basis risk (as we note below) in the two indices but the divergence is dramatic and is also shouting loud and clear in Europe too as the big six major US financials see credit spreads at 3-4 weeks wides while stocks are holding up overall. While XLF is increasingly divergent from the TBTFs, we would not expect it to be able to hold up if they all crack.

In arbitrage land there is a trade here, in retail ETF land - its tricky, one could perhaps leverage the LQD (investment grade bond ETF) exposure to financials as a proxy for the credit leg. By way of example, one might want to hedge the interest rate risk from LQD (so it becomes a more pure credit risk play) and trade that against XLF (the financials ETF) though obviously these are apples-to-elderberries comparisons. Back of the envelope math suggests Buying 2130x LQD, Selling 2100x IEF, and Selling 45x XLF in hope for a reversion but the basis in this trade is large given the flows in all of them and the different underlyings.


The green vertical line shows approximately when the macro data hit this morning and turned a slow leak lower into a rip-snorting rally monkey day. We assume when claims are revised higher next week then this will all be remembered and discounted back out - no confirmation bias here at all. As the USD sold off (green line inverted) then Treasuries (orange) sold off and stocks and gold took off with the midday momentum nudge from the ECB (orange vertical line) providing the impetus to take DXY lower and risk higher to help with pin risk on AAPL among others we are sure.


HYG (green) dropped notably out of the gate and trades at a discount to NAV once again - as we warned might happen once retail realizes that high-yield credits have a high-yield for a reason and carry can be ripped away from you very quickly by capital shifts. This sell-off in HYG (rather notably) was after the early ECO data but by the time the ECB rumor hit we were already off to the races. Stocks (blue) kept going and going while credit (red lines) slid wider in the afternoon - losing its will to ramp higher and still dramatically underperforming on a medium-term basis.


FX markets have indeed been a wild (if not massively volatile) ride this week with EURUSD reversing all of its losses from yesterday to close just shy of its European closing levels from yesterday around 1.3130. JPY continues to push lower (-1.7% on the week) which along with AUD and EUR strength lit a fire under broad risk assets as CONTEXT surged on the day (providing the risk-on support). The Treasury shift was a bigger magnitude driver though of risk-on appetite based on CONTEXT as rates increased and the curve steepened and twisted.

Lastly, we thought a fun experiment in total anchoring bias on this week's equity and FX price moves was necessary - if nothing else to prove we can use Excel again. For a 10pip rise in the EURUSD rate, we see a 7.1pt rise in the Dow. Conversely, when there is a 10pip drop in the EURUSD exchange rate, the Dow only lost 5.8pts this week (based on high-frequency data since Monday's open). All things being equal we would expect these offsets to be equal (we did this one log returns and absolute changes) - in this case we do not as equity upside from a EURUSD uptick is 22% higher than the downside in the Dow from a downtick in EURUSD. It seems indeed that our USD-based stock market is much more prone to upside moves than downside (at least this week) when USD weakness appears.

Gold almost reclaimed $1730 today but WTI remains the winner on the week (with Dr.Copper's ebullience clear today).


The small rise in vol into the close, lack of follow through in credit, modest Treasury rally, and stability in FX and commodities suggests that not all was gung-ho today (which makes sense if you spend any time actually trying to understand what is going on in the ECB and Greece). While macro US data is indeed better than expected there are skeleton after skeleton in those cupboards and every time I hear some talking head mention "money on the sidelines" a little piece of me dies. 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?

Charts: Bloomberg


No comments yet! Be the first to add yours.