Bad Credit

The big week is finally here, but before addressing the Fed tomorrow there's some unfinished business from last week that requires attention.  On the matter of Tom, Dick, and Harry, their true identities are:

Tom:   GDX times pi.   It's quite a base that it's trying to form, and if you buy it, you clearly know where you're wrong!

Dick is the Australia vs New Zealand two year swap spread.  While markets are understandably nervous on Australia given the goings-on in China, the domestic economy continues to chug along, thank you very much, apparently unobserved by anyone in the Northern Hemisphere.   The swap spread is at it highest level in more than two years, yet AUD/NZD has taken a bath recently and is back down towards very long term structural support.  Given the strong relationship between the two, Macro Man likes AUD/NZD here.

Harry:  Three month EUR/USD forward points divided by e.  Between the October and December ECB meetings, EUR/USD moved in lock-step with the forward points.  Since Eurogeddon, the forwards have largely come back, while the euro remains fairly close to its highs.    It's positioning, for sure, but nevertheless worth noting that the tangible reason that people were short EUR still remains.   The hopes and dreams of free Maybach Uber rides financed by unlimited ECB largesse will, sadly, remain unfulfilled.

And now, credit.   Friday's bloodbath may not have been the end, or even the beginning of the end, but at the very least it marks the end of the beginning.    There was clearly an element of capitulation in Friday's price action; not only did HYG and JNK melt down, but they did so on extraordinarily high volume.    Indeed, Friday's dollar amount traded in the two ETFs was easily a record, and more than double the volume of any trading day prior to last week.

Moreover, not only did both ETFs move to a discount to their NAVs, but in each case it was the largest discount of the year.   If that's not "just get me out" price action, well, Macro Man doesn't know what is.  And small wonder, too.  Macro Man calculated since-inception costs basis figures for the two ETFs using daily inflow/outflow data and assuming that on average the market is filled on the daily closing price.   For both HYG and JNK, the since-inception average purchase price is above the current stock price.

Of course, you buy high-yield credit for the, er, yield, so it's important to take dividends into account and look at total return.  Unfortunately, even doing that, just about anyone who's bought JNK since the beginning of 2013 is offside...

...and the same with HYG.

Even nastier, both ETFs have seen net inflows this year from the JBTFD crowd.   The average cost basis for 2015 buys in HYG is $88.83, versus a current price of $79.52.  There's an even worse profile in JNK, with an average 2015 cost basis of $38.87, versus a closing price of $33.69.

All of this is a fancy way of saying that people are selling because they're losing money....which you probably knew already.  Now, of course, is the time that all those concerns about market liquidity and the absence of market-making risk principals to intermediate between urgent sellers and not-so-urgent buyers come to the fore.

Thankfully, Dolores Umbridge has assured us that the financial system is safer thanks to all the regulations she's helped enact, which is comforting; not as comforting as not hemorrhaging money if there were someone to take the other side of your sell order, mind you, but still....take your blessings where you can.

And just for the record, let's just be clear that it is not the impeding Fed rate hike that's the cause of all of this kerfuffle in credit.   Obviously energy prices have played a big role via deteriorating fundamentals, but as discussed that's more of a supply story and a China story than a US financial conditions story.

No, from Macro Man's perch the market mechanism is the real scare story here.  The Volcker rule has eliminated principal market risk-taking in banks except for the Treasury market.  Of course, this raises the question:  if prop trading is bad, why is it permitted in the Treasury market, which from the government's perspective should be the holiest of holies?  On the other hand, if it is good and useful for ensuring a proper market mechanism in Treasuries, why should participants in other markets not be afforded the "luxury" of not getting screwed by slippage every time they try to transact?

Answers on a postcard can be addressed to

D. Umbridge, Ministry of Regulation, c/o Hogwarts School of Financial Remediation.

In the meantime, ponder the idea that there are still 19.6 million more shares of HYG and 41 million more of JNK than existed at the end of last year, and ask yourself what those holders are going to do in the coming weeks.   Then ponder on what professional holders of high yield and other credit will do after having gorged for the last several years only to see the wheels finally start to fall off.