Archive for September 18th, 2012
Tuesday, September 18th, 2012
Mitt Romney’s foot-in-mouth disease becomes all the more apparent.
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Bob Janjuah: “Central Banks Are Attempting The Grossest Misallocation And Mispricing Of Capital In The History Of Mankind”
Tuesday, September 18th, 2012
The always delightful Bob’s World is out. Here are the fmr RBS strtgist’s latst non-abrvtd thots:
When Money Dies
Before providing an update I wanted to refer readers to two items – which may in turn “give away” my thoughts “post-OMT” and “post-QEinfinity”. First, readers may wish to reconsider a piece I wrote earlier this year in February entitled “Bob’s World: Monetary Anarchy” (20 February). Secondly – and much more interesting in my opinion – all readers are urged to read the book When Money Dies by Adam Fergusson.
In terms of my thoughts, I think historically important events may be unfolding. I think that by their actions both Fed Chairman Bernanke and ECB President Draghi may have belied how deeply worried they are about our economies and the financial system. In short, I see fear in their actions. But what really concerns me is that their only responses are to effectively say “we give up”, as they abandon the search for “real” solutions to our ills. Instead, by their actions, we can now clearly see that the only solutions that are offered by the Fed and the ECB are the extension of the same failed policies that got us into our financial and economic despair in the first place. Namely MORE debt, MORE bubbles and MORE monetary debasement. When future historians look back for the day that the West lost its status as global economic superpower, and for the day that the West lost its aspirational leadership in terms of sound economic and prudent financial system management, I feel that September 2012 may be seen as a significant pivot point.
Turning to a few specifics:
1 – Politics: Both Draghi and Bernanke now seem to have deeply and irrevocably immersed themselves into the realm of politics. A review of Draghi’s speech made on the evening of 6 September seems to show, in my view, that he is deeply political and is prepared to use the ECB to further his own political agenda of a federal Europe. As for Bernanke, whilst he may not be so explicit, he will surely realise that his actions are likely to impact voters in the US elections in November. History tells us that politics and central banking should never be allowed to co-mingle. The results when this has been allowed to fester have usually been very undesirable. In my view, we have crossed a critical Rubicon here. My biggest fear now in this respect is that in Europe the (mostly) elected political leadership will – when it comes to delivering fiscal union – fail to follow through, and/or the people of Europe will refuse to co-operate in the Draghi-mandated push for federalism and fiscal union. And in the US, if Bernanke’s actions are perceived by Republicans to secure Obama a new four-year term, I see it as now highly likely that the fiscal cliff will become a full-on reality rather than just a thing we worry about. After all, a Republican Congress will have little to lose and lots to gain potentially by triggering a fiscal crisis IF they conclude that Bernanke has become a political servant of the Democrats.
2 – Growth and inflation: Lest we forget, neither QE, nor the LTRO, nor the OMT either have, or will, do anything sustainably positive for growth. The evidence of the last four years is clear. In fact, all I think we are likely to end up with is WEAKER growth as consumers are forced to save more and as they see their disposable real incomes fall. The idea that consumers and/or corporates will now go on a leverage and consumption/investment/spending binge is based on nothing other than hope – I actually expect the opposite to occur. The emerging world will be forced to TIGHTEN policy as the globally traded prices of food, energy and other commodities will serve to generate real and significant inflation in these nations. These higher “headline” prices (in non-discretionary items) will – in the West – cause growth to weaken as (discretionary) demand will take the hit; Western workers have zero pricing power and aggregate employment in the West will not improve largely because QE and OMT do nothing to generate global demand. Some might feel that a weaker USD will benefit US exports. Here one should not forget that the West is and has for the last five years been in a race to zero when it comes to currency strength. USD weakness will not be tolerated for long by the rest of the world, hence any US “gains” would be purely temporary. One major lesson of the last five years has been forgotten, or indeed rewritten. The recovery from the 2008-09 collapse was NOT primarily caused by QE1. The real drivers were TARP (real fiscal loosening) and the USD4trn fiscal and bank-financed investment binge seen in China from late 2008. I think it is crucial to remember this when the Fed in particular is “judged” over the next few months.
3 – Credibility: Central bankers who lose credibility are a major problem. I will leave it for others to judge, but the success of central bank policy over the last four to five years when it comes to creating jobs, boosting real demand and improving Western worker competitiveness is, frankly, paper-thin. In fact, the opposite is easier to prove. I see nothing in this latest and most dangerous round of monetary anarchy that will reverse the process of deflationary debt deleveraging, other than a short-term impact on the pace of deleveraging, and whilst QE and OMT have and will boost asset prices, this is again a very short-term outcome, but possibly at a truly enormous cost. Further, specifically in terms of the Fed and QEinfinity, I am deeply worried that what Bernanke is now de facto saying is that the real underlying economic and jobs situation is much worse than we all think, that he has no idea how bad or for how long this situation will get or will last, and that as a result the only tool left is a permanently open monetary spigot. Anyone who carefully considers his actions will, I think, end up as concerned as me. Regarding the promise to keep rates lower for longer I can only conclude that either (a) this policy will succeed and so result in enormous inflation (eventually) based on the explosion in M0 and based on the Fed’s 30-year track record of failing to take away the punchbowl before it’s way too late, which will trigger the next collapse; or (b) the policy will not succeed (my base case). Either way, the Bernanke Fed, which helped cause the US housing bubble, then helped cause its collapse, who first told the world there was no housing bubble, who then told us that all we had a minor USD20bn-odd sub-prime problem, who went on to tell us that QE was a temporary emergency policy that would be soon reversed, and who persists in telling us that QE will help deliver millions of jobs and will bring us back to pre-crisis levels of trend growth (above 3%!) – he does after all keep telling us the problem is cyclical and not structural! – is now very much in the Last Chance Saloon. Markets and political leaders, and the US people, may well judge Bernanke in an extremely negative way over the next few months if this latest huge gambit fails.
4 – Demographics and Behaviour: These are areas which get little focus in financial markets and with policymakers, who are both generally always looking for instant gratification and doing anything to avoid the reality that money debasement solves very little in the short run and creates huge problems in the long run. But I think they matter. The demographics in the US, in Europe and in China are, at least for the next few years, very negative (i.e., rapidly ageing). Ageing populations grow slowly. They save more, they spend less, and they do not go on debt-funded consumption binges. If consumption is weak, if uncertainty is high, if fiscal policy is having to be tightened and if global central bank policy settings are already at such historically emergency settings, I find it extremely hard to understand why any CEO/CFO will feel that now is the time to lever up, to invest, to hire, or to grow. If I am right about the private sector response, then Bernanke and Draghi will have to imagine up new justifications for their actions at the very least!
“The bottom line is simple: The Fed and the ECB are directing
and attempting to orchestrate the grossest misallocation and mispricing
of capital in the history of mankind. Their problem is that
their actions have enormous unintended and even (eventually) intended
consequences which serve to negate their actions in the shorter run, and
which could create even bigger problems than we currently face in the
near future. Kicking the can is not a viable policy for us now. The
private sector knows all this, consciously and/or sub-consciously,
which is why I feel these current policy settings are doomed to fail. Having
said all that, the one area which for some reason still holds onto
hope that Draghi and Bernanke can still perform feats of “magic” is the
financial market, which central bankers assume, rely on and are happy
to encourage Pavlovian responses. The reality here though is that even
financial markets are, collectively, either sensing or assigning a
half-life to the “positives” of central bank debasement policies, which
to me means that even markets are only suggesting a short-term benefit
from the latest policy actions. This is not what Draghi and
Bernanke are hoping for, but in order for them to see the half-life
outcome averted they know that we need to see major political and
structural real economy reforms which somehow make Western workers
competitive and hopeful again. The track record of the last
four to five years inspires very little confidence that we will see
such great necessary reformist strides taken anytime soon.”
Notwithstanding this, in terms of markets:
1 – This Week: We are four S&P closes away from being stopped out on the bearish call outlined in my August note . It seems – let’s see how this week plays out – that we were wrong to believe that central bankers would not become so “political”. As we have captured around 300 S&P points in the sell-off that began in early April (1422 to 1275) and the rally that began in early June (1275 to 1425), and as the S&P traded at 1425 on the day my August note with its 1450 S&P stop was released, the extraordinary central bank actions of the last few weeks has resulted in a very small hit to “our year to date”. As said, however, my stop loss will be triggered on this Friday’s close if the S&P is still above 1450. So my stop-loss and I are at the mercy of the next four days’ price action. Real-world risk takers/investors may choose to exercise any such stop sooner but I will wait/accept the risk. But to reiterate, if the S&P closes above 1450 on Friday, the bear call of August is closed and initially at least I’d choose to go flat/neutral on a tactical basis. If my stop-loss is NOT triggered by this Friday’s close – a possibility, but not a probability – then I will write again, but my initial sense in such an event would be that the half-life upside cycle is even shorter then I currently think and has already played out. Let’s see.
2 – Rest of 2012: Clearly the caveat/stop-loss above needs to be addressed first. Thereafter, I feel markets are now fully hostage to the data and in particular the political ebbing and flowing in Europe and in the US over the next few weeks and months. And for that matter in China too where, in my view, the growth slowdown seems to be accelerating, where handover to new leadership will delay until March 2013 any genuinely aggressive and detailed stimulus plans, and where the market is increasingly beginning to understand the huge risks inherent in trying to boost growth through another round of investment spending, where investment as a share of GDP will be at untenable levels (over 50%!) if all the stimulus headlines currently announced become a reality. Or alternatively, and in our base case, the market will quickly figure out that all/most of the currently announced investment plans are just that, merely plans, where little/no funding is in place and/or where funding plans are vague/non-existent, and where the market will figure out that the bulk of the announced spending plans are merely a restatement of existing plans. As such, of the USD2trn+ of plans announced, I expect only 5-10% to come to fruition on any reasonable and useful timeframe. Bottom line – in my view, and unlike in 2008-09, China capex is not going to prevent China’s bumpy (at best) landing and is certainly not going to be a meaningful boost to global demand. In general I expect material data weakness globally. And as politicians have generally proven themselves to be unable to deliver the real structural changes we need, then being long risk over the next few weeks and months may feel like the right “trade”, but I do believe that the maximum upside is around 10% to equity markets (from here), and furthermore, capturing this 10% will be one of the riskiest and most stressful phases of the market rally out of the 2008-09 lows. The scope for a complete reversal in sentiment and for gapping risk-off price action is very high, so being long risk over the rest of 2012 needs to be done with extreme caution, needs to be very tactical and liquid, and will require a willingness to potentially go against the Fed and/or the ECB. Probably the most important specific items the markets will now focus on are the US fiscal cliff and debt ceiling debate, where the risks of a negative outcome are, in my view, now higher after the recent actions by Bernanke, the lack of political follow-through and worse-than-expected economic performance with respect to Greece, Spain and Italy, and in general the outlook for global growth (where the US and China will, I think, disappoint).
3 – Longer term: No change here – we continue to favour/recommend high quality non-financial corporate credit and we continue to recommend any equity exposure be focused on high-quality, big-cap blue-chip non-financial global corporates. In essence, we still favour the “strong balance sheet” rule when it comes to investing (rather than trading).
Lastly, and for avoidance of any doubt, my 800 target for the S&P is truly alive and kicking. Actually, the recent Fed and ECB actions give me HIGHER confidence in this call. All that I think has really happen – at best – is that the August through November risk-off phase we forecast has been by-passed by the historic moves by the ECB and Fed, and we have now gone straight to the final leg of the 2009-2012/13 cyclical bull market, which I have talked about frequently. As set out in my previous few notes, we have long felt that we would get major QE/monetary debasement around December time, which we felt would take the S&P from 1100 (my target for the bear forecast we made most recently in August and which we thought we would see by November) up to new cycle highs out of the 2009 lows. A quick and dirty look at the charts would imply that by H1 2013 we could see mid- to high-1500s on the S&P. So as per above, if I adopt my most bullish stance possible, I can see the S&P rallying another 10% from here over the next two to six months. However, I believe that this will be the “riskiest” 10% to try and capture, that this possible 10% upside move can truncate and reverse at any time, and that it will be followed by what I think will be a severe repricing of risk over the rest of 2103 and 2014, which should deliver my 800 S&P target.
Tuesday, September 18th, 2012
The last two quarters we have seen quite a deceleration in S&P 500 earnings – in fact the S&P 499 has been flatlining. But Apple has a massive out sized effect on earnings (and hence supporting S&P 500 earnings growth). The NYT has a piece out this morning where they extrapolate a potential negative growth rate on said earnings, even with Apple. With export revenues hurt by Europe and to a lesser degree “emerging markets” (China, India, Brazil, et al) and profit margins falling from record highs, this is definitely an issue. That said stock prices are part earnings and part multiples – multiples are always an unknown; we saw how high they could get in 1999 when Uncle Alan flooded the world with liquidity ahead of Y2K.
- Wall Street analysts expect earnings for the typical company in the S.& P. 500 to decline 2.2 percent in the third quarter from the same period a year ago, according to Thomson Reuters, the first such drop since the third quarter of 2009. Earnings are expected slide 3 percent from the second quarter of 2012.
- “A lot of the profit gain you had in the last few years was a bounce from the recession and a result of very aggressive cost-cutting,” said Ethan Harris, chief United States economist at Bank of America Merrill Lynch. “Those factors are going to be very hard to replicate.”
- What is more, 88 companies have already said that results will come in below expectations; 21 that have signaled a positive outlook, said Greg Harrison, corporate earnings research analyst at Thomson Reuters. “That’s much more pessimistic than normal,” said Mr. Harrison, who added that the third quarter of 2001 was the last time that earnings guidance leaned so heavily to the downside.
- After rising steadily in the wake of the recession, profit margins for S.& P. 500 companies peaked at 8.9 percent in late 2011, said David Kostin, chief United States equity strategist at Goldman Sachs. Margins are expected to fall to 8.7 percent in 2012. (still a great figure)
- While profit margins have plateaued in corporate America, productivity gains in the overall economy have ebbed as well. After rising at an annual rate of 2.9 percent in 2009, and a 3.1 percent pace in 2010, productivity inched up 0.7 percent in 2011, according to the Bureau of Labor Statistics. “There’s only so much you can cut,” said Chad Moutray, chief economist at the National Association of Manufacturers.
Tuesday, September 18th, 2012
Adam Hewison’s Daily Technical Update, updated at 1:00 p.m. each day, provides a clear eyed into daily market activity. Hewison, a seasoned Chicago trader, and founder of MarketClub/INO.com shares his decades of trading and investing knowledge LIVE every weekday, providing insight and technical outlook, into stock indices, equities, currencies, commodities, and precious metals.
Tuesday, September 18th, 2012
by Peter Tchir, TF Market Advisors
The Feedback Loop Between Corporate Bonds and Their ETF’s
This has been an occasional theme for us, but after some conversations last week, think it warrants a deeper look. The various parties interacting in the market have become more correlated and the relationships more intricate. The growing use of ETF’s by institutions is a key part of that self-reinforcing feedback loop.
A now regular occurrence is a bond trader gets “lifted” in the morning or sells bonds and is left short. That trader waits all day hoping to find a seller of those bonds. At the end of the day, rather than lifting an “egregious” offer, or going home short, they will buy some ETF’s to cover the market risk. Of course the next morning, everyone sees the spike in the ETF and views it as a sign that the market got really strong into the close, so they try to buy more bonds. This behavior first became noticeable in the credit markets with the creation of CDS indices but is now occurring with more frequency in the ETF space.
The “arbitrage” community also plays a role in these loops, especially when quoted bond “prices” don’t reflect the reality of where the bonds would trade.
To understand how the feedback loop can create problems, particularly in a down market, it is worth going back to seeing how credit traded in the “old days” like 2007.
Bond Sell-Offs in the “Old Days”
Joey, the trader at a big market maker sends out a run on ShmoGo bonds. It is early in the morning, nothing much going on, futures a bit lower, but nothing that made the trader put much effort into the generic bond run.
A client sees the run, and wants to sell. They call the trader directly, asking him to refresh the ShmoGo 7′s. Joey immediately guesses the client is a seller, so rather than “repeating” the 99.5/100.5 market from the run, quotes the bonds 99/100. The client is a bit annoyed as he clearly hoped to sell at 99.5. The client that proceeds to explain that everyone and he means “everyone” is 99.25 bid, won’t the trader take a couple at 99.25 to save him from having to call around? By this time, the customer’s salesperson has gotten involved and clearly thinks this is generous of the client, since the trader just flaked on the price and pushes the trader. Now feeling trapped and getting sucked into buying bonds he doesn’t want, the trader protests a little, asking what the client is doing with their overall position.
The trader knows the client has a big block of these bonds and is legitimately concerned that if the client is exiting, then this purchase of a couple million will end very badly. The client insists they are just “trimming” the name. ShmoGo’s are a core part of our strategy, we still love the name, but are just lightening up to cut back from an aggressive overweight to a more normal position. At this stage, trader finally accepts and buys $2 million ShmoGo 7′s at 99.25.
By this time, it’s off to the morning meeting. The trader brings up the “axe” of having to move some ShmoGo 7′s at 100. They spend a half hour going through axes that are unlikely to be filled and listening to a couple research people drone on about some other company that looks cheap and another that is lucky not to be filing tomorrow.
Meanwhile, finally back on the desk, having missed some weak economic data at 8:30 while in their meetings, futures have declined a bit more. There is a slight “risk-off” feeling.
Sales are on the phones with their clients. Senior sales figuring out what their clients want to do and how to get it done, and junior sales trying to flog the morning axes, not completely aware that non of the bids are likely to be there now that the weakness has accelerated.
A little while later a salesperson asks the trader where he is on the ShmoGo 7′s. The trader, a little exasperated by now, shouts out that he can offer them at par, and asks just under his breath, “weren’t you at the morning meeting?” This gets a little chuckle from the entourage of traders around him. Sales is less impressed, but they were expecting this. The respond with, “okay, that’s what I thought, but my guy is telling me that’s pretty generic as its is 99/100 everywhere, and he thinks he could get the bonds at 99.5″. The trader asks the salesperson if their client is a buyer, and after a brief pause while the salesperson checks with the client, he gets the answer that no, they aren’t a buyer, were just giving some color.
As the morning drags on, a couple of other traders manage to get hit on bonds and it is clear that the market tone today isn’t good. Not horrible, but certainly no strength.
The trader gets to work. He sends out a fresh run ShmoGo 7′s 99/100* (where the * indicates “better” seller). He calls one of his interdealer broker, and after chitchatting about last night’s game, yet again, he tries to get some sense on ShmoGo’s). The broker said he’s had a few traders come in checking on the name, thinks they were sellers, but has nothing live. The trader says to work a 98.75 bid, but to work it lightly. The broker can’t help from smiling, so you’re there, but not really looking to be worked? Exactly.
So the trader has done his best to create a “picture” that the bonds are 99/100 and the street is “bid without”. He knows the 98 ¾ bid isn’t really going to help the picture, but he’s got a bad vibe about the situation and is getting concerned the original client might actually be out there spraying the street with these bonds.
One of the earlier salespeople comes back asking for a refresh on the ShmoGo 7′s. The trader immediately knows the client isn’t looking to buy bonds. They would have engaged him much differently, asking him “what was the best level on the offer?” or something similar. This is clearly someone trying to get him to make a two-sided market so he can hit the bid. Ever careful, the trader responds, “I went out 99/100 but am a seller only right now”. The salesperson immediately frowns, because they too knew what the client was trying to do. After a short conversation with a disproportionate amount of nodding, the salesperson walks over to the trader. This isn’t a good sign.
The salesperson is looking for a firm bid. The client wants to sell a couple bonds, and wants to know the real bid. The trader, doesn’t want to buy the bonds, but also doesn’t want to lose control of the situation, so they say they would buy pay 98.5 for a couple. Since he had bid the street 98.75 earlier, he figures the client has probably seen a lot of 98.75 and 98.5 bids and wasn’t going to hit his 98.5 bid “on the wire”. Sales trudges off to make the call, acting as though he had been horribly wronged, making it obvious to everyone that he was embarrassed by the traders “lowball” price. As sales gets on the phone, the face changes, a big smile, he has found something, or at least he thinks he has. He shouts across, so everyone can here, “my guess says he would sell us $2 million at 99 and leave us an order for 3 more”. Sales is quite happy as 99 was the bid from the last run, and an order on a few that they could work riskless has to be great news. The trader is far from happy. Now there is a block seller, below where he bought bonds in the morning. He says the best he could do is pay 98.5 for a couple and work something higher, but, he tells the salesperson, they are working on developing a block buyer (not a total lie, but not completely true either, depends on your definition of “developing”). He tells sales, that if the client is patient, they would take his bonds along when the block buyer came in.
He looks down at his phone to get research on the line, to help this situation and sees the broker’s line flashing. He doesn’t even have to pick up the wire to know that the little spiv is trying to hit him on his old 98.75. Sure enough, “hey, um I know you didn’t want to be worked, but you know I’ve got a guy who said if he can get the bid back, he’d sell bonds there”. No. That trade is easy to duck, but now what.
The situation isn’t great and the client didn’t hit the 98.5 bid, so now is about as good as time as any to grab a coffee. If he’s on the desk, someone might try and hit that bid, and certainly no one is coming to buy bonds, so it is time to hide mode.
The firm spends the rest of the day trying to find a buyer. People aren’t really talking about a specific price, but “in the context”. Everyone knows the bonds are probably 97.5/98.5 right now. The top salespeople don’t really focus on the axe, because they know the trader bought bonds higher and isn’t about to sell them in the right context, yet. He would need some more pain before that happens.
They do have one client, who they are pretty sure is short the bonds, but that client is as sketchy as they come. They maneuver the world of opaque, over the phone bond trading, finding the mistakes and taking advantage of them. This is a dangerous call to make, but they risk it. The client claims that not only do they not want to cover, but they might short more. Not good. It is too bad the market maker can’t hear the laughter at the client. One analyst asks the PM why aren’t you covering the short yet? It has gotten to the price target. The PM just laughs. He has watched this trader for years, and knows that if he hit a 98 bid, the bonds would be coming out at 97.5 tomorrow when the trader got the tap from management.
So, by the end of the day, the trader goes home with a couple million of bonds bought at 99.25, that are realistically 97/98, though mostly quoted 97.5/98.5 since another dealer had managed to get hooked and bought some bonds at 98.5, probably to work an order on 3 more from the client who had passed on that deal earlier with this firm.
The next morning, the firms that bought go out as 98/99 seller only. Others are 97/98, but you can’t hit a 97 bid, when there is a 98 “bid” even though there really isn’t a 98 bid. Yes, this is weird, but true. If 2 dealers are sending out runs saying 98/99 seller only, all you really know is that bonds are offered at 99. Yet, somehow, it is hard to sell bonds below that fictitious 98 bid. Especially since the sellers could have sold much higher than 97 the prior day.
So now the market just sits there another day as everyone tries to protect their position.
While this may be an exaggeration to make a point, there will be a lot people out there who think I’m talking about them (I’m not). ETF’s, just like the CDS indices, change this.
How is it different now?
The ETF’s, similar to the CDS indices, can create a feedback loop.
There is no place to “hide” anymore with one sided runs. The ETF’s show you where the market is heading. CDS did as well, but not everyone gets CDS pricing, and many traditional bond investors, choose to ignore CDS when it moves opposite to how they want the market to move. Then the CDS market is all about “technicals” and hyper trading macro people who “know nothing about credit”.
It is harder to ignore it when the ETF’s are moving. If any bond you wanted to sell is either offered only, or down more than a point on the bid side, but HYG or JNK have barely budged, you sell them. They are “beta” management tools. At some price you will attempt to manage market risk rather than name specific risk.
So far so good, but the real feedback loop occurs when the ETF goes “cheap” to NAV. If the ETF is outperforming, it is easy to see why someone would sell that against their bonds, but why would you sell if the ETF was “cheap”?
Because it isn’t really cheap, it is actually expensive still. If all bonds started the day at 99/100, the NAV would be 99.5. If the market weakens and all bonds are quoted 97.5/99.5, the NAV is 98.5, so only down 1%, but in the real world, if you are a seller you are down at least 1.5 points (from 99 to 97.5). So now you can sell the ETF down more than 1% because although NAV moved only 1%, the bid side dropped more. Also, with bid/offer increasing in the bond market, the cost of selling a bond and having to buy it back has skyrocketed, making the ETF’s (or CDS indices) more appealing.
So now the ETF leads the way and shows the real flows. Any chance a dealer had of selling bonds at a high price is pretty much gone. The transparency makes it harder to hide, and brings down offers quickly, making the market seem “heavy” causing bids to pull, and ETF’s to sell off more.
That is risky enough, but the ETF “arb” like index “arb” is what typically creates the next wave of the feedback loop.
While a real bond investor is unlikely to hit the “low” bid, an ETF arb client might. A real investor will see how quickly the bid has dropped and determine what they think is the best course of action. They might not sell here thinking the market has gotten ahead of itself. They might sell something else. They might short the ETF (yes, there is a propensity to short something you don’t own, even if it is “cheap” rather than taking the hit on what you own, I understand it, I’ve done it, but it is unhealthy).
So while traditional bond investors can commiserate with their salespeople over how quickly things gapped down and strategize about how to play it, and traders can try to avoid having long pushed in their mush, there is a group of traders who don’t think like that.
All they need to know, is if they can hit 98 bids on X number of bonds that the ETF’s are looking for, they can hit those bids, buy the ETF, do a redemption, where they exchange ETF’s for the bonds (to get net flat) and take out a profit if the ETF is trading cheap enough.
This group of traders isn’t concerned about the absolute price of the bonds, because they didn’t own them before, and won’t own them again in a few minutes (slight exaggeration). All they care about is the relationship between the bonds and the ETF.
In credit markets, and high yield in particular, this puts the single name risk in the exact wrong hands, at least if you are looking for stability. It means market makers are getting hit on bonds on levels they didn’t think possible, in a falling market. At some point, any hopes of greed and crossing the bonds for some decent coin get replaced by fear. What does someone know? How much is coming out. Intellectually they might know it is the arb, but they won’t be able to stop themselves from getting some protection such as shorting the ETF. The market maker stops worrying about making and losing eighths and quarters and worries about losing the notional amount. At that moment, they need to get out.
So far we haven’t seen a full feedback loop on the downside in the ETF space. We came close a couple of times, but it never quite seemed to crack. We have seen it on the upside. I would argue that much of the rally in the first part of this year, was because the ETF’s were trading at a premium and the self-fulfilling feedback loop was in play. But on the upside, the fear, even of being short, never hits the same way as the fear of being long. Being short, especially at record prices on bonds, doesn’t have the same danger as being long. So that feedback loop isn’t as dangerous.
On the other hand, if you looked at CDS, we had a big feedback loop this year. We saw it happen with the JPM IG9 trade unwind.
Just a Theory, Not a Warning
I don’t see anything to trigger this loop right now. Europe is doing some things to reduce risk. The Fed is pumping money into the system. I’m not concerned about this occurring anytime soon, but while we have such a quiet day, I figured it was worth explaining, because if and when we get a loop like this on the downside there will be no time to explain.
In the meantime, one reason I’m comfortable being neutral on high yield up here and don’t think there is any urgency to buy is because the premiums of the funds don’t indicate strong demand or that the arb activity will be there to support the feedback loop. I sent out to some people last Wednesday why I thought the CDS market would outperform ETF’s, and that is still my view, and has a lot to do with the bonds that make up the high yield index and their rate risk exposure for some, and horrible convexity for others.
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