Wednesday, May 5, 2010

Debt markets as an indicator or trade

Only relevant to traders and analysts

Quite a while back a trader asked about debt markets as an indicator. The trader focuses on equity options. In light of what is going on in Europe, an update to the response is worth posting. However, it is quite limited in depth. The trader’s question focused on not being blindsided by the end of the world while making some money trading very short term. Here’s the response; it has only been lightly edited.

Yes, debt markets were the source of the financial crash. It went way beyond being an indicator. Once debt markets realized how many people weren’t going to pay back their borrowing, debt markets froze. It started with mortgage debt, but spread via the shadow banking system. The cause of the spread was that liquidity was needed to adjust for the mis-priced Mortgage Backed Securities. The rush to liquidate (i.e., get liquid) rippled through every market in the shadow banking system. Any market and therefore any organization with a liquidity mismatch became vulnerable. That transformed a liquidity- driven contraction into a generalized fear about counterparty solvency. That was one of the unintended consequences of mark-to-market accounting as interpreted under Sarbanes Oxley.

I don’t need to go back and check. One of my kick-myself-moments was watching this happen, knowing what was happening, seeing the indicators, explaining it to people, and not trading it aggressively.

Currently, there are a few things to watch, but they are more as fire alarms than trading guidance. One should watch the relation between the short term Treasury rates and the LIBOR…the interest rates not the prices. If they start moving in different directions, it warrants a second look. It’s somewhat of a one way indicator. This can indicate when things are very bad, but most of the time it is a "no news" story. So, it generally doesn't get coverage.

If the LIBOR goes up while Treasury rates are going down it indicates something is wrong. People with money don't trust the financial system. That is exactly what happened going into this crisis.

The opposite can be timing differences as the Fed raises rates, but they shouldn't be large and shouldn't last. This is something to keep an eye on given where we are right now. If it gets large or lasts, it would indicate a reduction in the confidence in the Fed and Treasury. Specifically, it could indicate a lack of confidence in the ability of the Fed and Treasury to control inflation.

From an equity-timing perspective yield spreads between corporate debt and Treasuries are a good indicator, but the spreads have tightened enough that recently there wasn’t a lot of information in their movement. However, they generally say where we are in the cycle. When it become inconsistent with where we are in the cycle, something is going wrong in financial markets.

The problem with using debt to time equity markets in the short run is that there are so many automated trading system that rebalance big portfolios real time and daily. They kill any easy money; that leaves us manual traders with the need to interpret debt markets as well as equities. Debt markets convey a lot of information, and there is a lot less noise (i.e., random movement getting big news coverage) than in equities.

Over the next few years, one should also watch long-term Treasury rates. The Fed and flight-to-quality are holding them down, but at some point the Fed will have to stop monetizing the national debt. The flight-to-quality right now is giving them a chance to start the process without having to thread a needle. There is a good chance the Fed will miss this opportunity for reasons related to global impacts. Thus, when Fed does start tightening, the speed with which long rates rise will indicate whether the recovery aborts. It could be important early next year, say March. But a lot depends on what happens in Europe.

There was an important disconnect going on for most of this year. Gold and debt markets were making two very different forecasts. Debt markets were forecasting slow growth and price stability. Gold is forecasting inflation. They were closely reflecting currency trading but with short periods where they disconnected from the dollar and started trading on their own scenarios. The movements in both were bullish for stocks over the short run. That has changed as gold stopped rising and debt markets, especially in Europe, finally realized there is risk in sovereign debt.

This is the disclosure relevant at the time. You may remember a discussion we had about gold trades. I got in below 1K for the trade I wanted. But, the other side of the trade was puts on Treasuries as a hedge for the corporate bonds I had rebalanced into. The disconnection referenced above (gold and debt markets) resulted in the bonds going up in price. The hedge wasn’t necessary. Net, I got where I wanted to be, but it was more complicated than I like.

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