Market Snapshot: Equities Up (Led by Financials) But Well Ahead Of Credit

A funny thing happened right after the 'successful' EFSF vote in Germany, equity-credit-and-EUR sold off in sync, but this moment of sanity amid the chaos that is the European corporate capital structure did not last as soon after reaching swing lows, European equities surged dramatically ahead of credit markets only to pull back into the US open and stabilize. On a medium-term basis, stocks remain significantly expensive relative to credit expectations but with such a binary outcome (depression or safe-union) the smallest swing in the odds of one or the other tips risk assets rapidly in that direction (as opposed to discounting over a broader set of scenarios).


Strength in credit into the close is a little misleading - not wanting to pour too much cold water on what was a great day for long-only equity strategists - since the indices (following their roll in credit derivative land last week) have traded very significantly wide of fair-value (the price at which the index would trade if one created it from the underlying names in the portfolio) and today saw a huge compression in the difference between the index and its fair-value (the skew). Point being, while the indices appeared all bright and bubbly with 2.5bps compression in Main and 8.75bps compression in XOver, a significant amount of that is 'technical' in nature as professionals bought protection on underlying names (which notably underperformed the indices) while selling protection on the index.

Just to add some more complexity to your day, a lot is also being made of the strength in US financials (moreso bonds than stocks) with XLF holding in at +2.6% while Discretionaries and Materials have tested red today. A few things are worth noting: 1) its month- and quarter-end which suggests managers want to show some exposure to these names heading into Q4, 2) given their underperformance, rebalancing any 'balanced' long-only index-mimicking portfolio will require rotation into financials even if you think they stink, and 3) CDS and bonds are not in agreement on today's action (especially in the big financials).

Point 3 is perhaps the most interesting (and less well known). CDS and bonds necessarily have to maintain some semblance of relationship (via an arbitrage framework) even though very different technicals (supply/demand/flow) may impact one or the other. When the two markets disconnect enough - e.g. bonds become very cheap relative to CDS or vice versa - then hedge funds (and dealers) will step in and scoop up the difference in what is called a basis trade (buying bonds AND buying CDS protection to narrow the difference relatively risk free). Today we see heavy net buying of financial bonds (which we are sure is helping exaggerate financial stock performance as much as it is) but we note that dealer-to-dealer activity is high and, more importantly, CDS on the majors are leaking wider and wider since the open. This implies bonds are being bought and hedged via CDS and so while all looks rosy when we look at the TRACE flows and see huge net buying in financials' bonds, only when we combine that with CDS spread movements to we get a clearer picture that reality may not be quite as exciting. Math lesson over for today!

FX markets have oscillated all week with a general lower USD bias with today's movement dominated by early strength in the EUR followed by a slow and gentle bleed lower as the day wore on into the European close. EUR keeps bumping against the 1.675 area and pulling back while JPY ebbs lower (vs USD) and Cable (GBP) flows higher.

The small oscillations in the USD are nothing to the waves being seen intraday in precious metals and commodities as once again today we see copper, oil, and silver all move in 5-6% ranges and the more sedate gold in 2% ranges. For now copper has decoupled from oil and found a new friend in silver and gold as only oil is higher on the week (despite USD weakness).

TSYs are mixed today with 30Y yields modestly lower and short-dated yields higher though there is very much a butterfly style to the movement with 5Y notably underperforming the rest of the curve - an almost perfect mirror image of what corporate bonds are doing with the belly being more aggressively net bought than the tails.

All-in-all, optically markets look relieved and happy and as Pisani would say Risk-is-on, but under the covers, ES sits at VWAP (balanced) and we suspect technicals and window-dressing are strongly supportive for now (as opposed to risk appetite - we'll watch new issue concessions for that). Relative to a broad basket of risk assets, ES had sold off too far overnight and this morning pulled back to be more in line.


UPDATE: well that upset the apple-cart as darling of the carry currencies - NZD - gets downgraded - shifting FX carry and thus risk assets in general down with it.