Is the worst yet to come?
Weekly Credit Markets review 03.10 - 07.10
Friday’s close could not have been worse for the bulls out there. Closing at a new yearly lows at a time when the European and Asian markets were closed for the weekend will leave many exposed on Monday morning. I have no idea what may happen next week but one thing I am 100% sure of is that I don’t want to have any long positions. It is not so much as me not seeing any value in individual names but rather the potential for a very rapid sell off or even a crash like scenario. The risk to reward in any of these scenarios is not up to my standards and I avoid getting myself involved in such situations. I don’t see any compelling reasons for long positions at this stage and even if the long side does work out I view it as limited in upside and not so limited in downside. There is a famous saying - “markets take the stairs up and the elevator down” and I can assure that this explains very well how markets work in stress times.
Without a doubt this week’s highlight was the BoE’s intervention in 30Y Gilts. Not only did they postpone the already announced QT but they started a temporary QE. Quite the reversal. I can see why people were not happy with the decision to intervene but my unpopular opinion on the matter is that the alternative would have been significantly worse not just for the UK but for all developed markets as UK pension funds would have accelerated their deleveraging in multiple asset classes which would have likely triggered margin calls in other institutions causing a domino effect. They had not only (temporarily) saved equity and credit markets but saved many jobs. They certainly saved the day and bought time. It was the right move to do.
The intervention is supposed to last for 13 days with up to 5bn GBP per day in 30Y Gilt purchases. I wonder what would happen after the 13th day? Will they stop or keep the remaining money to use in case another emerging intervention is required in the future? Is there a yield cap which they would not buy above? Unfortunately, we don’t have answers to these questions but I keep wondering if a curve steepener trade in the GB curve makes sense. -0.65% was the low and can be used as a starting point.
Credit Suisse is the second big story trending this weekend. For some reason people are insisting they are in big trouble and may blow up. The whole story seems a repeat of the Mar’08 Bear Stearns fiasco, without the Twitter non-sense. It started with rumors about their financial health while their common stock was being heavily sold. The CEO then came out defending their liquidity but shortly thereafter they were bought by JPM. CS’s CEO came out on Friday defending the liquidity base of the bank saying they have strong capital base and liquidity but I can’t help to think about the parallel to Bear Stearns. To be fair, the CDS trading at 250 does not pose any bankruptcy risk, however it is up to the bank’s clients to view it as a safe bank and continue operating with it as a counter party. If their clients deem the bank too risky they will not trade with it and the banks liquidity position will deteriorate significantly. Looking at the CS credit , I don’t see any fear whatsoever. The perpetuals are down because of the repricing of the higher yields and subsequent breakdown in the AT1 market in general. It is certainly not related to any CS bankruptcy fears, however should heavy selling appear in CS credit this week, I will take it as a sign of trouble in the Swiss bank. As of the NY close on Friday there was no panic.
FIXED INCOME ETFS:
HYG - Further downside to at least the COVID lows may be expected if SPX keeps moving lower. As a friend of mine says: “High yield is just equity with a coupon.”
PFF - I do expect similar price action in PFF if we see the market slide further. As PFF’s largest holdings are convertible preferred stocks, it is more tightly correlated to the performance of SPX and the equity markets than the bond markets.
CURRENT TRADES:
MET-F long vs MET 3.85% short 1x3 size.
PGX long vs WFC 5.875% short 1x4 size.
POTENTIAL TRADES:
LQD vs HYG - One of the best risk to reward trades I found. I do believe that high yield should underperform significantly should we see further selling in the equity indices and the current level on the chart presents an excellent entry. In essence this trade may be viewed as a short momentum trade of SPX but with a significantly limited downside and very large upside.
If you are bearish on CS I can recommend shorting their debt instead of the equity. The perpetuals still have plenty of room to the downside. CS 5.25% perp or CS 9. 75% perp shown below as an example. Keep in mind, the AT1 market looks bearish and had a bad week, it is not only the CS perps that are down in the last week.
If volatility returns with full force I expect pair trading to be fashionable again and be the best source of alpha as that way directional exposure is eliminated. A an example from the COVID crisis below:
The cause for this divergence was a forced liquidation in VRP.
RISKS:
One of the biggest risks out there is the UK pension funds fiasco to spread over to the Europe. The amount of negative yielding debt that was issued in Europe in 2021 is mind boggling and should we see potentially higher rates in Europe the magnitude of the crisis will be biblical. For that to happen we need rapid jump in EU yields leading to significant price drops in the physical bonds. Obviously we are not there yet but what happened in the UK last week should not be forgotten easily.
Earnings season starts soon. Would we see more companies guiding lower before their actual earnings date?
Unemployment numbers on Friday - For inflation to cool down we need to get into recession. You do that by increasing the unemployment rate. Do we see first cracks in the labor market this Friday?
Credit Suisse blowing out. This will occur if we see further downside in bond and equity markets. I don’t think we are at a CS bankruptcy stage nor do I believe they actually go out of business but it can certainly increase volatility in European markets. Don’t forget that Deutsche Bank is in a similar situation.
SPX exacerbating the move to the downside will trigger deleveraging and possibly margin calls, especially if the move is sharp. Should that happen one should focus on very short-term trading or staying away from the markets. Remember, this is a trader’s environment, not an investor’s environment. Don’t be a hero.
The secondary market for issuers with upcoming refinancing needs will be under a lot of pressure.
CONCLUSION:
We may be entering the stage where volatility is so high that intraday trading is the only thing that makes sense. The equity and bond markets’ selling had been quite orderly so far and no real fear had been observed. This may change next week if the market holds steadily below 3600. Should that happen ETFs like HYG , PFF and other similar proxies should accelerate their selling, likely testing the Covid lows. I don’t think real fear had been seen in the markets yet. I am still of the intermediate view that all pops should be shorted while all capitulation selling should be bought.