*Our Macro team's quantitative model indicates a fairly balanced risk/reward outlook in the immediate term with XLF upside of 1.3% and downside of 1.4%.
* High yield rates fell to a new YTD low on Friday. This reflects both the perception around diminished risk as well as the Fed's policy to punish savers through zero rates.
* Interbank risk continues to recede with the Euribor-OIS tightening 3 bps and the TED spread tightening 2 bps in the latest week. The second round of LTRO is scheduled for Wednesday and the market expectation is currently for 470 billion euros in additional take-up with a range of between 400 and 750 billion euros. The first LTRO helped curb concerns about a European liquidity meltdown in the immediate term, pushing the Euribor-OIS from 98 to 65 bps since the start of the year. We don't expect the second round of LTRO to be as significant to the market as the first. The first round mattered profoundly, as it finally got the ECB out ahead of the crisis. Nevertheless, one of our key YTD themes has been reflating the European liquidity discount, and the second round of LTRO should be viewed as insurance against a near-term liquidity crisis resurfacing.
* Both European and American bank CDS tightened week over week, on average.
Financial Risk Monitor Summary
•Short-term(WoW): Positive / 4 of 12 improved / 0 out of 12 worsened / 8 of 12 unchanged
• Intermediate-term(WoW): Positive / 6 of 12 improved / 3 out of 12 worsened / 3 of 12 unchanged
• Long-term(WoW): Negative / 0 of 12 improved / 7 out of 12 worsened / 5 of 12 unchanged
1. US Financials CDS Monitor – Swaps tightened for 23 of 27 major domestic financial company reference entities last week.
Tightened the most WoW: RDN, MTG, AIG
Widened the most WoW: GS, MS, AXP
Tightened the most MoM: RDN, MTG, AIG
Widened the most MoM: GS, MS, C
2. European Financials CDS Monitor – Bank swaps were tighter in Europe last week for 33 of the 40 reference entities. The average tightening was 4.8% and the median tightening was 1.0%.
3. European Sovereign CDS – European Sovereign Swaps mostly widened over last week. American sovereign swaps tightened by 2.5% (-1 bps to 36 ) and French sovereign swaps widened by 4.1% (7 bps to 185).
4. High Yield (YTM) Monitor – High Yield rates fell 21 bps last week, ending the week at 7.11 versus 7.32 the prior week.
5. Leveraged Loan Index Monitor – The Leveraged Loan Index rose 2 points last week, ending at 1636.
6. TED Spread Monitor – The TED spread fell 1.8 points last week, ending the week at 39.7 this week versus last week’s print of 41.4.
7. Journal of Commerce Commodity Price Index – The JOC index rose 4.0 points, ending the week at -6.82 versus -10.8 the prior week.
8. Euribor-OIS spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread tightened by 3 bps to 65 bps.
9. ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB. Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system. An increase in this metric shows that banks are borrowing from the ECB. In other words, the deposit facility measures one element of the ECB response to the crisis.
10. Markit MCDX Index Monitor – The Markit MCDX is a measure of municipal credit default swaps. We believe this index is a useful indicator of pressure in state and local governments. Markit publishes index values daily on six 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. We track the 14-V1. Last week spreads tightened , ending the week at 125 bps versus 127 bps the prior week.
11. Baltic Dry Index – The Baltic Dry Index measures international shipping rates of dry bulk cargo, mostly commodities used for industrial production. Higher demand for such goods, as manifested in higher shipping rates, indicates economic expansion. Last week the index rose 1 points, ending the week at 718 versus 717 the prior week.
12. 2-10 Spread – We track the 2-10 spread as an indicator of bank margin pressure. Last week the 2-10 spread tightened to 167 bps, 6 bps tighter than a week ago.
13. XLF Macro Quantitative Setup – Our Macro team’s quantitative setup in the XLF shows 1.3% upside to TRADE resistance and 1.4% downside to TRADE support.
Margin Debt - January
We publish NYSE Margin Debt every month when it’s released. NYSE Margin debt hit its post-2007 peak in April of 2011 at $320.7 billion. The chart below shows the S&P 500 overlaid against NYSE margin debt going back to 1997. In this chart both the S&P 500 and margin debt have been inflation adjusted (back to 1990 dollar levels), and we’re showing margin debt levels in standard deviations relative to the mean covering the period 1. While this may sound complicated, the message is really quite simple. First, when margin debt gets to 1.5 standard deviations or greater, as it did last April, that has historically been a signal of extreme risk in the equity market - the last two times it did this the equity market lost half its value in the ensuing period. We flagged this for the first time back in May 2011. The second point is that margin debt trends tend to exhibit high degrees of autocorrelation. In other words, the last few months’ change in margin debt is the best predictor of the change we’ll see in the next few months. This is important because it means that margin debt, which retraced back to +0.55 standard deviations in November, still has a long way to go. We would need to see it approach -0.5 to -1.0 standard deviations before the trend runs its course. There’s plenty of room for short/intermediate term reversals within this broader secular move, as we saw in December and January's print of +0.53 and +0.70 standard deviations. Overall, however, this setup represents a long-term headwind for the market. One limitation of this series is that it is reported on a lag. The chart shows data through January.
Joshua Steiner, CFA