Dec 14, 2014. Sliding into year end
What a mess this town’s in tatters I’ve been shattered
My brain’s been battered, splattered all over Manhattan
Uh-huh, this town’s full of money grabbers — Rolling Stones
The theme now has become higher quality credits vs lower quality, and uneasiness with the latter is becoming pervasive. One look at the treasury market reflects demand for the highest quality, but there are numerous other indications of stress, including the surge in high yield spreads, under performance of small cap stocks this year, the collapse of inflation premia, the downgrade of France to AA by Fitch on Friday. Remember when we were constantly reminded that the subprime mortgage sector was a mile wide but only inches deep? That it just wasn’t large enough to really shatter the larger market? I don’t know how it compares to the current environment, but a DB report says energy companies are 16% of the HY market, and that oil below $60 would push this sector into tatters. If it’s all about oil, one might think that perhaps the US might stop the slide by announcing major purchases for the strategic oil reserve. But the benefits of lower prices for US consumers and the prospect of further damaging Russia’s economy are a much bigger (short term and short sighted) incentive. It is the US energy sector that has been providing jobs; that engine has now stalled. Energy production also requires capital investment, plans for which have been scaled back.
–In terms of Friday’s price action, the ten year yield fell another 7.7 bps to end below 210. 5/30 treasury spread continued its collapse, now at 122.4, down 0.5 on the day. Ten year treasury to tip now below 165 bps, down 7. I rolled my curves forward as EDZ4 has expired, but the red/gold pack spread, though +2.25 on the day, is only 130 bps when using March contracts as first red and gold.
–Implied vol is expanding. I marked FVH vol at 3.8 and USH at 9.0 (having adjusted for the weekend). Earlier in the week, USH atm straddle had settled 4’00, vs Friday’s 4’32. Measuring against the Oct 15 spike, I had FV at a high of 4.5 on that day, and US at 12.5, followed by 4.0 and 10.3 on the next day (Oct 16). 2 vols are worth one full point currently in USH, so at 11% rather than 9%, USH straddle would be 5’32 vs 4’32. VIX closed at 21.08 Friday, 10 points lower than Oct 15 spike high.
–Another little red flag is waving: Russell 2000 small cap index. While all the other indexes made new highs throughout the year, this one has gone sideways, having made its high for the year in July. Since the end of November, Russell has mapped out a perfect head and shoulders top, having closed just below the neckline on Friday. Closed 1152, H&S objective around 1110.
–One last note, Congress passed a bill that continues to provide a gov’t backstop for bank derivatives, tossing out a key Dodd Frank provision. Almost as if to tell the banking sector, “We know that the oil drop is causing financial dislocations…we got your back.”
