Financial markets appear to have had a Damascene moment on Friday evening, receiving an epiphany that has carried over into today's trading. Simply put, markets seem to have decided at some point on Friday afternoon that the dizzying array of bailouts, programs, packages and nationalizations that have been directed at the money markets is finally enough to fix the problem.
Swap spreads started to tighten aggressively on Friday p.m. and have continued to do so today. US 2 year spreads, the locus of recent madness in the funding markets, have tightened 40 bps in the last week. They remain at historically sky-high levels, so there remains ample scope for further tightening of the spread. At the same time, LIBORs are being called quite a bit lower; again, while they remain at starkly exaggerated levels relative to policy rates, it now appears as if the worst has passed and that they will continue to be marked lower moving forwards.
Tomorrow's Lehman CDS settlement remains one prominent possible thorn in the side of policy normalization. So risky markets may struggle to tack on much more upside until tomorrow's settlement is successfully resolved.
Assuming that does come to pass, Macro Man would not be surprised to see a decent rally in risky stuff. The combination of an easing of the worst of the crisis and the impending US election could give markets all the excuse they need to rally.
And there is, of course, nothing wrong whatsoever with making money on that rally. Yet once the passing of the crisis has been fully digested, where will we be left? Still staring into the jaws of a bone-crushing recession. And while US equities are certainly less expensive than they were a few months ago, Macro Man's analysis suggests that they are far from cheap.
His macro equity model, which attempts to forecast 12-month forward returns for the SPX, registered its two lowest readings in history at the end of August and September- one reason why he was happy to run short equity deltas for most of the last six-seven weeks. He has re-run the model for October, using his best guess for those inputs which have yet to officially print this month.
As you can see, while the forecast is less awful, it still ain't good. While Macro Man can see a scenario in the next six months where the outlook turns quite positive, by his reckoning we ain't there yet. Thus while Friday's Damascene moment may signal the beginning of the end of the funding crisis, there appears to be a long, hard slog ahead to convert equities into a bull market.
Swap spreads started to tighten aggressively on Friday p.m. and have continued to do so today. US 2 year spreads, the locus of recent madness in the funding markets, have tightened 40 bps in the last week. They remain at historically sky-high levels, so there remains ample scope for further tightening of the spread. At the same time, LIBORs are being called quite a bit lower; again, while they remain at starkly exaggerated levels relative to policy rates, it now appears as if the worst has passed and that they will continue to be marked lower moving forwards.
Tomorrow's Lehman CDS settlement remains one prominent possible thorn in the side of policy normalization. So risky markets may struggle to tack on much more upside until tomorrow's settlement is successfully resolved. Assuming that does come to pass, Macro Man would not be surprised to see a decent rally in risky stuff. The combination of an easing of the worst of the crisis and the impending US election could give markets all the excuse they need to rally.
And there is, of course, nothing wrong whatsoever with making money on that rally. Yet once the passing of the crisis has been fully digested, where will we be left? Still staring into the jaws of a bone-crushing recession. And while US equities are certainly less expensive than they were a few months ago, Macro Man's analysis suggests that they are far from cheap.
His macro equity model, which attempts to forecast 12-month forward returns for the SPX, registered its two lowest readings in history at the end of August and September- one reason why he was happy to run short equity deltas for most of the last six-seven weeks. He has re-run the model for October, using his best guess for those inputs which have yet to officially print this month.
As you can see, while the forecast is less awful, it still ain't good. While Macro Man can see a scenario in the next six months where the outlook turns quite positive, by his reckoning we ain't there yet. Thus while Friday's Damascene moment may signal the beginning of the end of the funding crisis, there appears to be a long, hard slog ahead to convert equities into a bull market.
16 comments
Click here for commentsVery nice model, seems to have correctly anticipated several difficult years (ie bubble, 06). However, it was also wrong several times, and if it is based mostly on macro inputs it will be misleading this time for the single reason of inflation. I believe everyone is seriously misunderestimating what inflation expectations will be in 6 months due to the solution to this crisis being inflation, whereas previous recessions you would simply wait it out with a tad more public spending. What did you input for inflation expectations?
ReplyPS: I would love to see that model posted weekly/monthly, it looks like quite the oracle.
Thanks, great blog.
I share your feeling that there are some signs that sentiment is spreading that financial crisis has been finally fixed, and this could provide a bid for risk assets for some weeks. Still i'm worried looking at what'happening in HY world: Xover index keeps widening 25 bps per day and single names underperforming, maniy names > 40 upfront. This reflect credit crunch assailing industrials, firms breaching triggers, banks cutting lines. While a huge surge on default ratio looks unavoidable to me, lack of temporary improvement here dumps in my view the tactical rally i would like to play.
ReplyGoing forward, a turning point in next 6 months looks optimistic to me, but the speed of recent developments tells me that this is a far too forward looking forecast.
sick trader
BOYKOTT U B S
ReplyNach Versagen auf der ganzen Linie, kann die Inkompetenz und arroganz dieser Abzockerbande zu Lasten der Allgemeinheit nur durch einen
Total Boykott der UBS von allen Privaten und Geschäftskunden bestraft werden. Dieses Verhalten akzeptieren wir Schweizer nicht.
Die Parteien seien auch gewarnt – ihr müsst Euch ja der Wahl stellen, also hütet Euch.
Keine Geschäftsbeziehungen mit der UBS mehr.
The tightening of swap spreads/easing of financial CDS is very likely due to the sovereign/financials convergence trade. Given all the state guarantees, this makes sense. A rising perception of sovereign risk , however, could cause the next crisis, if some govts. run into trouble trying to finance themselves.
ReplyThanks for a great post as ever
Anon @11:03 AM -- but the sovereigns will probably do fine funding themselves if-and-when OPEC cuts production to bump up the crude forward curve, right?
ReplyAnon @11:03 AM -- but the sovereigns will probably do fine funding themselves if-and-when OPEC cuts production to bump up the crude forward curve, right?
ReplyThere are several potential problems I see going forward.
Reply1 Massive government debt issuance pulling funding away from domestic investment in a slowing global economy forcing rising interest rates for other types of loans.
2 Possibility of a policy blunder of raising taxes and with the batting average for these folks being what it is not a bad bet.
3 A very severely wounded hedge fund community sill facing redemptions threw year end.
4 With the overhead losses of buy and hold investors who didn't sell, any rally may be sold in an attempt to just get back to even and cut the losses.
5 Rising unemployment.
I think you're right about a positive upswing in the very short term, but I think volatility will shoot up again as we get into November. Overall I think 2009&10 look very bearish. Deborah
ReplyBears of a feather flock together?
ReplyData watching now, or rather the market's reaction, which I think will be most telling. Also curious to see how the curves digest the glut of funding coming on tap, John Jansen said 40bp tail on recent May 2015 reissue - any further colour MM?
Certainly one indicator is the number of pundits calling bottom, plus lack of -ve GDP prints leads me to believe we have some way to go. My gut says pullback likely in interim due to shocks of recent moves, my head says stay nimble.
Cheers, JL
JL, the reopenings/guesses on future issuance seem to have wrought absolute havoc with the US curve. I am no fixed income RV guy, but every day my Bloomberg inbox is peppered with messages highlighting the volatility, illiquidity, and damage in the US curve as various spots cheapen and richen with jaw-dropping speed and scale.
Reply"staying nimble" is, I think, the name of the game. My biggest risks are now long term long-option positions in stuff I really believe in; while I might get hurt on vol-selling, the delta of many of these will work.
My short-medium term risk at the moment is very, very low as stuff is SO noisy.
Macro man:
ReplyWithout revealing your model, could you say something about why the forecast is slightly better now? Is that due to some real-world data that came in positive or is it due to some mechanics of the model?
Thanks.
Johan
Great blog MM. Two metrics that all are watching are the VIX & the spreads. I see both have come off as you mentioned & Libor to boot.
ReplyOne word comes to mind....can u say whipsaw ??? Remember just a few months ago when they thought the corporate/treasury spreads were retreating (Oh, things are getting better)& then it just turned out to be a dip YIKES !!
Apart from SWFs going long last week (they're probably still going long) some US mutual funds are also going long this week.
ReplyBy Christmas the market should be at much higher levels than it is right now.
Hopefully someone on this forum was silly enough to take my anonymous advice to do a curve trade on Brent yesterday... I didn't.
Reply"Without revealing your model, could you say something about why the forecast is slightly better now?"
ReplyI would guess the change came from a huge drop in prices.
The model looks at various measures of valuation, growth, and "competition for investment dollars." I don't really want to go into more detail because, well, I have a family to feed...
Reply