With most market participants (what’s left of them) traditionally narrowly focused on one specific asset class, be it stocks, bonds, rates, or commodities, they sees a few trees but miss the whole forest – a perspective which has to include all cross asset perspectives, which in our day and age is quite complicated, to say the least, due to the prevailing and oftentimes irreconcilable cognitive biases among such traders (all of which tend to interpret Bernanke’s market signaling in their different way). So courtesy of Citi’s Stephen Antczak, here is a comprehensive summary how every single asset class is viewing the market right now.
Color from our finance desks…
No net new shorts: Risk may have picked up with the end of QE beginning to be priced in, and there has been a dramatic increase in short activity in the stock market given this backdrop. While shorting skyrocketed so did covers, though. As such, on a net basis and at the aggregate level there were no new shorts. In fact, the short-to-cover ratio in May was the second lowest this year!
Macro hedging is dominating: To the extent that there was shorting activity, it was very much driven by macro hedging. This is evidenced by the fact that ETF shorts jumped, but single name activity did not.
Everyone is nervous about higher rates: It is not just in the fixed-income market that investors fear higher rates. For example, the utility sector – a relatively rate-sensitive segment of the stock market – registered five of its highest short volume days in May.
Repo team says that…
There is more inquiry but less activity: Over the past several weeks the number of inquiries to locate corporate bonds to short essentially doubled. Typically, around 50% of inquires actually end up in trades, but in recent weeks only about 15-20% of inquiries were executed (with us, anyway; Figure 4). This could mean that while investors are wary of market conditions, they may not have much conviction at current levels, at least at the single name level.
No focus on long duration bonds: We expected to see more inquiry for longer duration corporate bonds given that everyone seems to fear higher rates. In fact, prices in the back-end are off over $9 on average, far more dramatic than the $2.8 setback experienced by the typical short-to-intermediate bond (Figure 5). But instead most locates were for either high-beta bonds, story names, or for credits owned by PE funds.
Treasury players are wary of…
Concern #1: Yields have jumped, vol has spiked, the risk markets have sold off, and the Fed has said fairly little to reassure the marketplace. Perhaps wishful thinking to expect any reassurance from the Fed, but still.
Concern #2: There has been net selling from asset managers, which has been fairly unusual in recent years. This color is consistent with the reversal in flow trends as reported by EPFR. Specifically, Figure 6 shows that almost $250 bn has flown into fixed income mutual funds from early ’10 through April of this year. But over the last two weeks, we have seen $8.5 bn of outflows (Figure 7).
Concern #3: Despite the sharp sell-off, yields are still very, very low, and absent QE and possible continued outflows, who knows where a new buyer in size will care?
Futures desk says that…
Risk on at current levels? Valuations in select market segments — even those that theoretically should not be particularly sensitivity to higher Treasury yields — have been under severe pressure. For example, Figure 8 shows that generic implied vol levels in the credit space spiked in recent trading. As such, some investors are looking for opportunities to scale in and take advantage of dislocations.
Shorting the rates markets: There has been a definite bias to use options to express any bearish rates views. Cost is part of it, but also important is the challenge of predicting the Fed’s actions as well as the negative experience from shorting Treasuries in recent years. Maybe it is not a given that Treasury rates will rise.
Equity desks note that…
They are seeing buying on weakness: There is an underlying bid for the stock markets in both the U.S. and Europe from real money investors, which is consistent with the recent reversal of equity market fund flows (Figure 9). Worth noting is that select names with more U.S. exposure have been in demand abroad.
Be wary of the crowded trade: Many trades are crowded at this stage; it is certainly not just a credit market phenomenon. For example, TSLA was a name that was very popular on the short side and the name more than doubled during the month of May in large part due to short-covering (Figure 10). Hedge funds have been looking to trim exposure to consensus / crowded positions.
Color from EM group is that…
Higher rates + slow growth = investor concern: Again, the markets that may be vulnerable in a no-QE environment are those that are exposed to higher Treasury yields but are not particularly well positioned to benefit from stronger growth (U.S. or otherwise; Figure 11). Select portions of the EM space fit this profile (in fact, the EM ETFs are some of the top shorts).
Profit-taking: That said, in general the flows in this space seem to be more consistent with profit-taking rather than aggressive shorting activity.
Putting it all together…
The risk-on sentiment for U.S. corporate assets is likely to return. Higher Treasury yields are creating technically-induced dislocations, and with default risk remaining muted higher yields will ultimately lure investors to take advantage. This is particularly true given that in the wake of recent volatility negative market characteristics are becoming less negative (e.g., dollar prices, all-in yields, etc.).
That said, we are currently in unchartered territory with respect to the rates / credit relationship. In particular, by some metrics the proportion of credit investors with mark-to-market risk is at an all-time high while the Treasury yields are still near all-time lows. Who knows what could happen? Be very cognizant of tail risks. Also worth noting is that assets that are vulnerable to higher rates AND that are not well positioned to benefit from firmer fundamentals are susceptible in this environment.
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So that’s what Citi thinks (we assume one can’t sail a chartered yacht in unchartered waters?). Frankly, at this point (or any time over the past five years) nobody has even the faintest clue what will happen in a centrally-planned world. What we do know is that if all the “expert” desks agree that the time to BTFD is here (as always), Bob Farrell’s 9th rule says something else will happen.