Liquidity in credit is hitting an all time low, and is yet another warning sign of how fragile this market is.
MAIN, the European Investment Grade CDS Index is being quoted with a bid/offer spread of 1.5 to 2 bps. Last week it was still being quoted in 1 bp markets, which although wider than the more common ½ bp market, was still respectable.
Why is this so bad?
Let’s assume MAIN moves about 3 bps for every 1% move in equities (I think it is actually a little less than that, but close enough). So MAIN is 189.5/191 right now. If you want to get short credit, or buy protection, you pay 191. If stocks move 1% up or down, then MAIN should be 192.5/194 or 186.5/188. You could sell at 192.5 if you got a 1% move in stocks correct, making 1.5 bps. If you got direction wrong and had to close out, you would sell at 186.5 and lose 4.5 bps. The risk/reward of using the index as a hedging or risk taking tool has become skewed against you.
That means you are back to having to adjust your risk through your cash positions. So while the street has limited inventory, this could increase demand for bonds and push prices higher, but that seems hopeful. It is at least as likely that investors will want to reduce risk and have to look at selling bonds. With the street having no risk appetite, the pressure on the bond market would be intense.
Wide bid/offer spreads like this tend to occur in two situations. On a day with heavy one way flows, the bid/offer may widen. It forces those investors who need to go with the flow to take even more pain. That is often a sign that the market is about to reverse. The market may start out the morning at 170/171 and by lunch time is at 180/182 and then in a brief flurry goes to 182/185. That is more often not a sign that 175/176 is in the cards.
The other time wide bid/offer spreads occur is when the street has had enough. They cannot get whipsawed any more. Providing liquidity for the sake of liquidity is losing money every day, and with jobs at risk, they just give up. That happened in June in SOVX prior to one of its big breakouts wider. The decision to widen bid/offer so much across the street, feels like a prelude to a big move, and again, more likely wider than tighter.
There are other signs that make me believe the gap wider risk is higher than the gap tighter risk. Main is trading about 7 rich to its intrinsic value. This is not outrageously rich, but is a sign that the index has performed better than single name CDS. That is an indication that many hedges have been taken off, or investors are playing from the long end for a quick trade. Both in line with hopes that the summit would do something, and expectations that the Santa Claus rally was on its way.
The combination of wide bid/offer spread, trading rich compared to fair value, and even less liquidity in the cash market, is not good, and is far more likely to result in a gap wider than a move tighter.
Isn’t this normal for this time of year?
It is only December 14th. We are all so exhausted it may feel later than that, but the reality is it is only December 14th. The market is providing liquidity like it is 3 pm on December 31st. So no, it is not normal.
It also seems that the new spread is adopted by all the dealers. As far as I can tell, there is no entrepreneurial trader out there trying to make a name for him or herself by providing tighter execution levels. That would be typical. So no, this isn’t a normal behavior for this time of year.
If CDX Indices were cleared, or better yet, exchange traded, they could continue to trade with tight bid/offer spreads. S&P futures continue to trade actively and e-minis had an exceptionally busy day yesterday. It is at times like this, that the failure to get CDX indices on exchanges (or even properly cleared) is most felt by the market.
On the other hand, hedge funds that rely on making markets “efficient” are struggling to figure out how to make up money for all their bad trades. My understanding is that “predatory” trading has increased over the past couple of months as “spraying the street” or “catching market makes offsides” has become a primary trading strategy at some funds. These client, affectionately known as “pick off artists” by the trader, have received great liquidity as management has bought into the pleas from salespeople of “how important it is to see their flows”. That tide is turning as more managers are actually worried about real P&L rather than sales credits and the perception of being involved. The bizarre nature of CDS trading does largely help dealers as price discovery isn’t as high as in equities, but it also does help some fast money traders who are willing and able to take advantage of the situation. The street is pulling back to protect themselves, but that could backfire as it may finally give clearing of indices (if not an exchange traded product) the impetus it needs to finally get done properly in the 1st quarter.
I don’t see how we can get a strong rally until S&P has updated its ratings. Every day they delay we could grind higher, but until some clarity occurs on that front, it will be difficult to get a sustained rally. They may surprise to the positive side (though I doubt it), but the market needs to know what S&P is going to do to move forward. I believe that downgrades are coming and are not even close to being priced in. France will be a key. It will also be important to see what happens in other countries. Any country that was A- or higher that goes to BBB+ or lower will be important to watch. Any country that goes from being Investment Grade to Junk is also worth watching. Crossing those thresholds can trigger collateral provisions on deals they have. It can also exclude them from portfolios they are currently held in. That would be even more true of things like EFSF and EIB where they rely exclusively on their ratings as they are not true sovereigns.
Show me the money!
The IMF now has to produce real money. Same with the ESM and EFSF. Will we still bounce on every headline saying they have some new source of funds? Probably, but after being disappointed time and again, the market will need to see real actual money (or even real virtual 1’s and 0’s) before it can respond fully. All the believers have been sucked in and disappointed. The skeptics have been rewarded for being skeptical. Promises aren’t going to cut it.
The Euro breaking 1.30 is news. It will be bigger news if it breaks sufficiently and holds below. I’m not sure that it should be news. It isn’t clear why things like MAIN 200 become such focal points, but they do. There is more often than not support at those levels, but once through, it gets ugly fast as too much of the support was based on some psychological complacency on round numbers. All the doomers can turn up their “sky is falling” rhetoric by adding in comments about how Euro is at 12 month low etc. In practical terms it is probably irrelevant, but in a thinly traded, easily spooked, headline driven market, this will carry more weight than it should for the bears.
ETF Funds Flows
HYG, JNK, and LQD have all continued to experience inflows. They are all trading rich to NAV. This may be a sign of underlying strength. It may not be. The share creation process is a bit of a mystery for me. There seem to be two ways that shares are created. One way (the positive sign) is when market makers sell so many shares that they need to create shares. They purchase bonds to deliver into the ETF and get new shares in exchange. The other way (less positive signal) is when dealers buy bonds that they can’t sell, so they convert those bonds to shares of the ETF so that they can sell the more liquid ETF’s back to retail.
So there is definitely some retail demand, driving both the positive NAV and share creation process, but I think it is not very deep. Cash bonds, while not weak, certainly aren’t flying off the shelf in a way to justify a premium to NAV.
We are trying to figure out ways to model the demand flow. We suspect that on the more positive flows, the names that are the biggest and most liquid components of the ETF’s get bid up. Dealers caught short shares need to buy bonds quickly so they can participate in share creation. They would focus on big liquid names. Trying to see if those are the bonds that are added during share creation or a deep bid for those bonds exists could be a good sign. If the bonds being used in share creation are more haphazard, then it would be more likely that dealers are getting hit on some bonds and using the ETF’s as a way out of their positions. HYG has much stricter share creation rules than JNK (in fact HYG is much stricter in most respects than JNK) which means we may see a pattern there as well, since most retail investors are indifferent, but desks would gravitate to the easier share creation product if they were using it as a liquidity enhancing tool.