Credit Markets 0808-1208

Focus points for the week ahead

FOCUS POINTS CREDIT MARKETS: 08.08-12.08

·         General Market overview: Friday’s strong non-farm numbers showed where the risk is – stronger economic numbers. The narrative is lower inflation, lower economic activity hence the fed being less aggressive with hiking. With the stronger than expected earnings season and still strong economic numbers this narrative does not look as strong as a month ago.  Several FED members had spoken out that they are not pivoting, they are data dependent and will act should inflation remain higher than expected. With the wage-inflation spiral working in full force I am not so certain how long the lower inflation and recession narrative can keep going, at least in the US.  My personal feeling is that shorting bonds and equities is the better risk to reward trade here, although a lower-than-expected CPI report on Tuesday may change the tone in an instant. Even if that happens, I don’t think the market can rally much more than 4200-4250 area. This is where I go short size. Remember that SPX rallied from 3650 area to 4150 in a month. Nothing goes up in a straight line.

In terms of bonds, I would want to be short the short end. I think European short end like the German 2 year and French 2 year are perfect shorts still, although the risk to reward is not as good as it was 1 week ago. I had tweeted several times about the case for shorting the German 2-year bonds. (Schatz). I am of the opinion that we will witness sustained flattening of the curve in the US and the EU following on their footsteps

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-          The market movers this week are CPI and PPI. If you are leaning long, it would be wise to put on hedges as we saw on Friday what could happen in a blink. If you want to short, make sure you are in the trades with a stop not based on the cash ETFs as the volatility may easily stop you out. What I mean is to better trade via options or use proxies of the ETFs like cash bonds. I personally am a big fan of options.

-          If this week’s CPI and PPI turn out to be non-events, we will be looking at the last week of August for more volatility when Jackson hole begins with a few economic prints in the same week

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-          Any rally in the 2Y US, 2Y German and 2Y French bonds (short-end) is a short opportunity.

·         Fixed Income ETFs:

-          Senior Loans - $SRLN and $BKLN are in the excessive moves land. Can they go higher, yes of course, would I buy them, hell no. Waiting for my level in $SRLN at $43.30, then will short. In the low volatility ETFs (like $SRLN) I like using the ratio 1x2 put spreads. Gives us very cheap entry with excellent risk to reward but the downside is they require a lot of margin. An example of a reasonable put ratio spread in SRLN 0.00%↑ is Sept’22 $43 - $42 1x2 put ratio spread for $0.09c. If SRLN 0.00%↑ keeps going up you cannot lose more than $0.09c. If it falls down sharply you can lose more than $0.09c as you have extra short size on the $42 leg. Put ratios work well when there are no sharp gap downs.

-          Perpetuals - $FPE and $VRP are also in the excessive moves land and yet again I won’t touch the buy button in both. Looking for any market weakness to short them for a quick 2–3-day scalp likely by shorting them naked or via put 1x2 ratio spreads.  

-          High Yield - $HYG is still playing with the 100d SMA. It is a good level to short, but we need a catalyst, likely the CPI print on Tuesday. If you are into shorting it, like me, I would suggest shorting on Monday before the close either via  naked cash bonds or via put ratio spreads.  

-          Municipals - $MUB was affected by the sudden spike in short-term yields. This ETF’s duration is low hence the larger effect.  I don’t see a trade in $MUB.

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·         Credit spreads: CDS indices like the iTraxx Crossover and CDX HY index are approaching support levels where we could see bounces. Keep in mind that these indices are very sensitive to the Equity Indices moves so a minor sell off in SPX will cause a jump in the CDX HY. As of right now there is nothing of interest to report in the credit spreads world

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·         Perpetuals: The US perpetual market is no longer moving at all. You should be just holding anything you bought from the bottom for yield generation if you are into this game. For us short-term swing traders there is no edge as of right now. We are out of the US perps. The EU perps (AT1s) still have room to grow but are not as responsive to the positive environment as their US counter parties. We still hold the EU perpetuals but are out of the US perpetuals.  

Risk factors:

-          CPI numbers on Tuesday.

-          Fixed Income charts getting very extended. $SRLN $HYG $PFF. At current levels I am looking for shorts in preferred stocks and HY bonds.

-          Market pricing 75bps in Sept with 68% probability.

-          10y-2y yield curve flattening to -0.49% on Friday. Very big move and very extended levels.

Current positions:

-          Short PSA-L, PSA-I, SCHW-J. Looking to establish more shorts in extended preferred stocks.

-          Long BDC Bonds – ARCC 2.875% 28s , MAIN 3% 26s, HTGC 3.375% 27s and PSEC 3.437% 28s

-          Long Yankee bank perpetuals – STANLN 4.3% perp, SWEDA 4% perp and INTNED 5.75% perp.

-          Looking to establish more shorts in $FPE, $SRLN and extended cash high yield and extended perpetuals

Potential Trades

-          Short $VRP, $HYG and $SRLN.  Can be shorted naked or via put 1x2 ratios. I prefer put ratios.

-          Short extended cash bonds.

-          Short German and/or French 2-year government bonds.

-          Many potential pair trades which I point out regularly on our twitter feed.

Conclusion

-          I think the next move in credit and equities is to the downside and began positioning by shorting the over extended preferred stocks like PSA-L/PSA-I and SCHW-J. I am actively shopping for more short positions, but the primary focus is only on over extended products, not just anything. Picking my battles wisely as borrow fees are a big burden to any short seller in the fixed income universe. Time is against you.

-          Looking slightly further in the future it will be very telling how deep the next sell off will be in bonds. If shallow, then we have a case for a sustainable rally going forward but it is still very early to tell. I am confident next move is to the downside, I just don’t know how deep the next move will be. That is why I won’t be placing farfetched target points.

-          Most important point when taking any position is to be sure that you have skewed risk to reward in your favor. That is why picking good levels and structuring the trade correctly is key to sustaining any success in trading.