The T Report: Herding Cats and Credit Market “Weakness”

Posted by on Aug 8, 2012 in Uncategorized | No Comments

Herding Cats and Obstinate Politicians

The mental image is so clear. Draghi, Hollande, and Obama, wiping the sweat from their brows with dust covered hands, having successfully corralled the Merkel. She’s still feisty and not happy about being in the pen, but they have managed it for now. Job well done, time for a well deserved refreshment after a long day.

It’s only then that they realize the Rajoy isn’t in the pen. They can’t believe their eyes. There is that damn Rajoy sitting on the other side of the river licking his paws preening himself. They cannot believe. They are stunned, flabbergasted, and about to go ballistic.

Seriously, after all the effort to cobble together something that they managed to convince the markets would turn into action is being derailed by the person who is most to benefit?

It is absolutely ridiculous, but it’s not as though they will just give up. They will corral Mr. Rajoy. It is inevitable and the real risk is whether Merkel is able to escape while their attention is focused on Rajoy.

So while it is concerning that Spain is not playing along, I think the pressure brought to bear will be great and Spain will accept something to keep the EU, ECB, and Obama happy.

Negativity Remains High

The markets have had a strong rally, and I am definitely seeing more bullish statements, and the media seems to be adopting a little more of a cheerleading stance than a week ago, but negativity remains high. As I wrote yesterday, I have continued to sell and am now by the smallest long position I have. I haven’t yet bought SPX 1,350 puts (I should have) but after yesterday’s sales, I have a small position. I think that is representative of many bulls. This is the underinvested bull rally, where very few, if any bulls have been aggressively positioned for the move from 1,380 to 1,400.

The perma-bears have grown angrier and louder. That makes perfect sense and doesn’t tell me much.

It is at the center that I still see a lot of bearishness. I read multiple reports today about how the ECB plan would create a problem for Spain and Italy because their average maturity would continue to decline. Serious analysts have taken the time to recommend selling the market because the average debt maturity will be too short. I saw this and had to think. I have been a proponent that the longer the better. Without a doubt getting Spain and Italy long dated, cheap money is far more beneficial than short dated money, but right now, let’s see them ACTUALLY GET SOME MONEY.

There is something about the need to write about the negative long term consequences of a plan that hasn’t been announced yet, that just makes me believe negativity remains too high.

Watch the financial news for a bit. How many people are getting set with an easy ball to spike down on the bull side (their normal tendency) yet refusing to take it? In some cases, they are going out of their way to find the bad side. In many ways that is an encouraging sign, as it is far more balanced than it has often been in the past, but it feels that the pendulum has swung and too much effort is being put into pointing out negatives. It isn’t as extreme as when the philosophy seemed to be to turn everything positive, but I think it is there.

So I remain convinced, that while the market has moved to a more balanced position, it is far from overly bullish.

Yesterday’s Credit Market Underperformance

IG18 actually finished ¼ bp wider yesterday. It had gotten down to 101.5 but finished the day 103 bid. This was in spite of equity strength and a reversal from the bidless market we had seen for several sessions. That is definitely something to watch, but the rally has been strong, and yesterday’s pause wasn’t met with much real pressure in single names as the basis is now only -2 bps. That is about the least rich that IG18 has been in awhile. This means that positioning here is becoming more balanced. It was getting hard to have a sustained rally while being 4 to 5 bps rich, but at a much more neutral valuation relative to fair value, it has room to tighten again, which remains my base case for CDS.

The high yield ETF’s both sold off a bit yesterday. HYG and JNK were both down about ¼%. That caught some attention. The first thing I look to for confirmation of weakness is HY18, the CDS index. That was higher by about 1/8. Not much, but not confirming weakness in the ETF’s. HY18 is a spread product, so that indicates spreads tightened. Then look at rates. Treasuries moved lower yesterday. That move was picked up by LQD and MUB which are very sensitive to treasury yields. High yield, as I’ve mentioned, now has a large segment of the market that is trading at such low yields, that it is more sensitive to treasuries than usual. Some of that will have impacted the market. Too many “high yield” bonds trade as low yield, so will track treasuries at least somewhat (why I have said repeatedly at these yields, individual credit, and individual bond selection is more important than the beta trade).

If High Yield was really weak, IRM wouldn’t have been about to issue $1 billion of 5.75% coupon bonds. Those bonds only traded up ½ point (so not as much free money as you usually get from a new issue allocation, but still better than a kick in the teeth). For those who care about ratings, these are B1/B+ bonds.

So, yes, there was some weakness, but mainly in the cheapest hedge (IG18) and mostly a function of treasuries rather than spread, and the real key, the new issue side, remains strong.

JP Morgan

I feel the need to point out that JPM closed at 37.01 yesterday, the highest close since the May 10th whale conference call. At one point, including the dividend paid since then, JPM hit 38. I am now virtually out of JPM. I will reload again, but above 37.50 just seemed far too good a selling opportunity to pass up. While the whale trade is out of the way (I remain convinced the residual is marked so conservatively and has so many reserves that even the worst summer intern could trade their way out of the residual and book a profit. There are signs that housing is stabilizing at these levels. Those are all good signs, but the risk of a nasty LIBOR headline concerns me at these levels. It has been a great trade for us, and we will continue to trade the name from the long end, and may add, but the main thesis is largely over now for me.

S&P 1,350 Puts, Could have, Should have, Would have, Won’t

All things considered, I will be looking to add back some risk here rather than continuing to sell. The amount of negativity still seems high. While it will be a pain to corral Rajoy, I find it hard to believe that after all the effort made, that Draghi, Hollande, and Obama will give up so easily. The credit market weakness that so many pointed out, seemed isolated to a couple things, relatively easy to explain and all part of a process that to me is as natural if it was preparing to break to new tights as much as it is a sign that it is about to turn around.

It still feels strange to be long, and feels even stranger to be looking to get longer as futures continue to drift lower, but the fact that so many people are happy to say how wrong I am, gives me comfort.

I am watching closely. It is possible that yesterday’s push through 1,400 and gap to 1,407 is all we get and I should have bought the puts, but for now I’m looking to replace what I sold and think we still push to a new high, largely because too many people are bearish and even the bulls are underweight.