Cross-asset - Outperformance of Crossover/HY versus Volatility and Spot Equities

"It is far better to grasp the universe as it really is than to persist in delusion, however satisfying and reassuring." - Carl Sagan 

As our good cross-asset friend pointed out to us today, the tightening of the Itraxx Crossover index (High Yield risk gauge in Europe based on 50 European entities) has been very impressive. The Itraxx Crossover 5 year CDS index was tighter by 70 bps over the course of April, whereas volatility on the Eurostoxx 50 was unchanged and equities were up 4%. The significant tightening in credit spreads is testament to the frenzy in yield chasing in the credit space. 

Itraxx Crossover 5 year index since March 2010 (roll adjusted) - source Bloomberg:

The decorrelation with implied 1 year ATM (at the money) Eurostoxx 50 equity volatility (chart 2 below) and versus the Eurostoxx 50 equity index is rising (chart 3).

Chart 2 - Itraxx Crossover versus implicit Itraxx Crossover spread via 1 year ATM Eurostoxx 50 volatility (18 months regression analysis):

Chart 3 - Itraxx Crossover index versus implicit Itraxx Crossover spread via Eurostoxx 50 index (18 months regression analysis):

Another disconnect or decorrelation can be seen as well in the below graph from CITI weekly credit research from Matt King and published on the 26th of April displaying the Itraxx Main Europe 5 year index (Investment Grade credit risk gauge on 125 European entities) versus CITI European Economic Surprises:

The gap between market levels and economic reality has seldom been larger, and it seems to be taking ever more credit growth to produce the same growth in GDP. Unless more of the central bank stimulus finds its way through to the economy, this opens up the risk of sudden corrections as markets fall back to earth. Markets may be right that the implementation of excessive austerity is bad news for growth, and hence for sovereign solvency. But not implementing austerity seems unlikely to lead them to fare any better — a realisation which seems yet to have dawned.
How long will it take for that to occur, and for markets to become scared once again? It is hard to tell, and yet we have been in this situation before. The chart below shows Citi’s European Economic Surprise Index plotted against iTraxx. Over the past few weeks, the economic data have plummeted relative to expectations, yet spreads have continued to tighten in. Similar divergences occurred at this point in each of the past three years; in every case, after a delay, spreads moved to follow the data. In 2009-10, the divergence lasted a good six months (Oct09-Apr10); in 2011 it took four months (Jan-May); in 2012 it took just one month." - source CITI

"The temptation is to say that something has changed, that we are immune to these problems, after the shocks to date which have failed to move spreads. But we doubt it. Tightening valuations and increasingly long investor positions ultimately create an obstacle larger than any individual news headline.

Most likely in the near term is markets just continue to follow the liquidity – and yet here too we think they are overestimating central banks’ largesse. Recent speeches suggest that the ECB, in particular, remains anxious that action on its part may lead to inaction on structural reforms elsewhere. Our economists expect a rate cut next week, but no major relaxation of collateral requirements just yet. Indeed, the opinion penned by the Bundesbank for Germany’s constitutional court, which leaked into the press this week, is a reminder of how the backstop on which the peripheral rally is predicated rests on remarkably shaky ground.

Where stimulus feels more assured (the US and Japan), where the gap to fundamentals feels smaller and risk-reward seems more symmetric (US HY and global equities), and especially where tranches and options can be used to tailor profiles so as to be long the tails, not short them, we are much more comfortable chasing the market. The same applies where there is a good micro argument for being long, such as our old favourites £ vs € (below), or bank sub CDS vs cash or senior fins, even when these have been working already. But in € credit in general, and in peripherals in particular, we see nothing to suggest this time is different." - source CITI

Liquidity rules...for now...and no ones wants the punch bowl to be taken away. Oh well...

"You can judge a leader by the size of the problem he tackles. Other people can cope with the waves, it's his job to watch the tide." - Antony Jay, British writer

Stay tuned!