Prisoner's Dilemma: Will Investors And The Fed Collaborate?

The recent market weakness (selling off in equity indices and widening in credit spreads) shares many elements of the previous dips this year, which should give bulls some comfort (the Italian- and Cyprus-led dips didn’t last very long). However, there are elements which are concerning – as Citi notes, positioning in long equity and credit positions are notably ‘long’, and how weak cash credit has been this time around. As Citi points out, investors and the Fed are trapped in a prisoner’s dilemma. Will everyone collaborate (investors hold to cash positions & dovish Fed) or betray (investors start unwinding cash positions & hawkish Fed)? The strategy each player follows will determine whether the weakness this time around is to be faded (like the previous ones this year) or not.

The following discussion – via Citi’s credit team – relates to ‘widening’ in credit spreads but is just as useful in considering the weakness in equity markets since the cap[ital structure arbitrage-led relationship between equity and credit as liabilities on the balance sheet of a ‘firm’ means that any disconnect cannot last long.

Via Citi,

The recent widening on the back of concerns about a “rates back-up” (and its potential to create substantial selling pressure across many asset classes) shares, at least on the surface, many of the characteristics of two widenings we’ve experienced this year: the “Italian”- and “Cypriot”-led widenings in the second half of February and March, respectively. In those two cases, the widening faded after one or two weeks.

This time around, the credit index has not started to tighten (rally yet)…

However, as we show below, positioning this time around seems more stretched than in previous widenings and cash credit has been much weaker than anytime this year. As we argued last week, we are at a pivot point, and we expect US yields (on the back of the Fed’s message next week) to give direction to the market.

(Upper pane – credit positioning is the most ‘net long’ since 2011… Lower pane – equity margin account debit balances highest ever)


In all the three widenings this year, the weakness has been led by synthetic products, with

(i) real money investors holding to their cash positions and hedging with synthetic instruments (indices, single name CDS and options) and


(ii) fast money investors playing the momentum with, again, synthetic instruments.

This is very clear when we look at how the bond-CDS basis (Figure 3 below – a measure of how derivatives are used to hedge relative to cash positions actualy reduced), the index skew (Figure 4 below – i.e. basis between the index and its single name CDS constituents – which is basically a measure of how much demand for quick-and-dirty macro protection is relative to more selective derisking) and index implied volatility have during all three widenings (Figure 5 below – how much protection is being bid)

In all cases, the demand for synthetic hedges led these metrics to widen.

However, at least in the Italy- and Cypriot-led widenings, investors unwound hedges after one or two weeks, causing all the bases to normalise, implied volatility to fall and index spreads to tighten.

Although our feeling is that the sequence of events this time around will follow a similar pattern, there are a few developments this time around which are markedly different from the two previous widenings this year.

First, as the chart above shows, reported long risk positions have risen to the highest since May 2011. Although our impression when talking to clients is still that they are “long but not extremely long” and that they are trying to “be prudent”, the starting point this time around regarding investor positioning seems to be much more stretched judging from the results of our survey.

Second, the extent to which investors have used synthetic index hedges this time around seems to be much higher, judging from how client positioning via iTraxx Main has changed since the beginning of each of the three widenings this year – see Figure 6 (above).

Third, and probably most importantly, although cash spreads barely moved during the Italian and Cypriot-led widenings, they have widened significantly this time around – see Figure 7. Is this time any different then?

In our view, the synthetic market has played its leading part already and it is the cash market that we should be watching. We believe the crowded long risk cash / short risk synthetic trade will be unwound soon, but it’s very different if that happens because investors unwind the synthetic short or because they start unwinding the cash long.

Bernanke’s words next week will be very important for investors to decide the best course of action in the current prisoner’s dilemma they face regarding cash unwinds.

Investors are realising that trying to save themselves ahead of anybody else (i.e. be the first unwinding cash positions in size) may be what gives the final push to the large widening they were trying to protect against. Wouldn’t it be better if everyone held to their cash positions? Central banks would generally agree on this – will they play the “collaborative” approach? If everyone collaborates, this widening will be like the previous ones this year.

Most credit investors we have spoken to actually seem to believe that, after a 70bp move in 10yr US yields, the Fed is more likely to strike a more dovish note at next week’s FOMC to break the sharp upward trend than to allow it to continue unchecked.

But positioning is a problem as we highlighted above and the Fed may not be as dovish as the market would like next week.


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