Yesterday we noted the growing divergence between US equities and US credit markets (with credit markets notably underperforming in the last few days). Today, the divergence has spread to Europe. The European equity markets have been on a tear for months as Draghi’s OMT theoretically removed downside tail-risk and European credit markets had followed along in a highly correlated systemic manner. The last week, however, has seen European credit markets dramatically underperform as a bid for protection in the CDS markets (for corporate and financial credit) has become very evident. The corporate bond markets have not seen quite such deterioration – as we suspect the market knows full well that with liquidity so thin, dumping sizable positions will have considerable market impact. The hedging of US equity positions (VIX disconnect recently), US credit (CDS disconnect), and now European credit (CDS disconnect) suggest more than a little concern at the current rally in stocks ability to proceed to new highs.

 

 

While we do not cover European credit (and equity) per se in our broad-based products (though are active for bespoke clients), we note our tactical asset allocation has picked up on these concerns and remains market-neutral – preferring to be exposed only to idiosyncratic risk in stocks (and not beta).

It’s been a great 2013 so far for risk-assets right? Wrong. Credit markets have hardly budged (spreads, as opposed to yields) as stocks have surged. We have seen this ‘risk’ disconnect a couple of times in the last few years and, well, it didn’t end well for stocks… but this time is always different.

In 2009/10, stocks surged as credit stalled… then stocks collapsed…

 

In 2011/12, credit’s highly correlated rally stalled and within a month the equity market had topped and rapidly fell back below the decorrelation level…

 

and now in 2013, HY and IG credit spreads have not partaken of this rally in risk at all…

 

It appears, as we have noted before, that credit anticipates and equity confirms. And just for clarity, this is credit spreads (not yields) and therefore does not represent a ‘rotation’ from bonds to stocks – these are apples to slightly different apples comparisons of two different markets’ perspectives on market risk…

 

There are a few reasons for the disconnect – from differences between cash (bonds) and synthetic (CDS) flows, call constraints in HY (thanks to ZIRP), LBO risk premia pricing in across some of the crossover space – but the disconnect is real (and along with VIX’s recent decoupling from stock’s exuberance) we are starting to see orange lights flashing – hence our Tactical Asset Allocation Stock Indicator is currently Market Neutral (preferring to beta-hedged than exposed to the broad market).

 

Originally posted at Zerohedge

We were invited to discuss our views on European and US markets as part of CNBC’s Fast Money show today. The discussion was brief but premised on the fact that our insights into the credit-equity relationship was flashing a major warning light in Europe and in the US and while Apple was sustaining broad US equity markets, risk is rising dramatically for a much more broad sell-off that should be hedged to market-neutral or shorted outright. Video Link here.

Full notes below (please bear in mind these were notes for the interview and not meant for public dissemination).

 

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As the S&P 500 reaches new multi-year highs and VIX touches multi-year lows, there is one rather large and risk-appetite-proxying market out there that is not as excited. The high-yield bond market has seen record in-flows dropping off recently and for the last four-to-six weeks high-yield spreads, yields, and bond prices have been very flat as stocks have surged ahead. Despite US earnings yields at near-record highs relative to high-yield bond yields, we see little pick-up in LBO chatter suggesting a notable preference for higher-quality junk credit (and/or lack of belief in sustainability of earnings yields) and the recent ‘dramatic’ outperformance in investment grade credit is a notable up-in-quality rotation (as well as early spread-compression reaction to Treasury weakness recently) that strongly suggests less risk appetite among real money managers (given how ‘cheap’ high-yield appears across asset classes). Lastly, the ratio of HY bond prices to VIX is near its extreme once again, something we saw occur before the risk flares of 2010 and 2011 surrounding the end of the Fed’s QE sessions.

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Our recent work on the growing disconnect between credit and equity markets in recent weeks was picked up by our good friends Gary Kaminsky and Rick Santelli at CNBC today. Furthermore, the topic of the LTRO stigma that we have discussed for over a week is becoming increasingly a concern – especially to those LTRO-encumbered banks. While the disconnect in Europe has been increasing for over a week, we have now seen US banks and broad credit markets also deteriorating quite rapidly – as we pointed out here today. As Gary points out, when we have had troubles in the markets before, it has tended to start in the credit markets and migrated to equities as the more liquidity-sensitive and capital structure focused professionals derisk ahead of the more momentum and retail crowd overshooting in equities…

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