The Day Italian Bonds Captured The Market

Yesterday’s trading was dominated by the stellar performance of the Italian bond market.  The stock market tried to give back some early gains on the back of a disappointing PMI report, but just couldn’t.  The Italian bonds in particular, but also Spanish bonds were on fire.  There was growing hope that LTRO2 had not been fully priced in and that we are at the early stages of another liquidity induced rally.  The LTRO announcement started strong, but faded, there was even a further sell-off, but the moment the Italian bonds started trading up yesterday, the market couldn’t help but follow.  Interestingly enough, the Euro did very little yesterday, and was in fact weak at times.  It is weak again today, but yesterday’s weakness is another possible indication that it is going back to trading on fundamentals – massive liquidity injections – rather than knee jerk reaction to Greece is saved, Greece is not saved news.  Also, as mentioned earlier, a lot of shorts have been cut and more analysts seem comfortable recommending long Euro positions lately.

So, LTRO2 may be about to spark that rally and “permanently” keep yields low, but at least this morning, the bonds have shown that Italian and Spanish bonds can actually trade down.  Not by much, mind you, but they are yielding few basis points more today than yesterday.  Portugal is wider again today, after being wider yesterday.  While we wait for PSI results out of Greece and the next steps there, the spotlight will shift to Portugal.  Of greater concern for the market will be the fact that Spanish yields are now higher than Italian yields.  Many people have wondered how Spain could trade better than Italy, and the most common argument (that made sense to me) was that the size of the market was smaller so the manipulation was easier.

With unemployment approaching 25% and already having to revise their 2012 budget deficit higher, the situation there is not good.  Small protests and strikes are becoming more common.  The housing bubble there burst a long time ago, but any material provisions for it seem to have been avoided, particularly at the Caja’s.  Again, LTRO is working so far, the market seems determined to go higher, but away from Greece, watch for growing disappointment on what is happening in Spain.

The ETF data is a big misleading yesterday, as it was dividend payment day.  The HY indices were actually up on the day of the dividend, but LQD was lower as the move in treasuries offset any spread tightening.  LQD is dangerous here as the bulk of the recent rally has been treasury driven.  The rate risk here seems much greater than can be offset by additional spread tightening.

JNK and HYG both started seeing strong inflows after a brief breather.  They have grown by over $6 billion this year, and have a combined market cap of almost $26.5 billion.  This is a very meaningful subset of the market right now.  Total volume in the 2 ETF’s was just under $500 million (HYG seems to be trading greater volume than JNK in general, and yesterday, that was particularly pronounced).  Daily TRACE volume in HY averaged around $722 million a day in the month of February.  So while there is concern about what the Volcker rule will do for liquidity, the ETF trading is chugging along.  The “indexation” of a product is a key change, and shouldn’t be underestimated.  This reminds me so much of what happened after TRACERS and HYDI were developed and how they changed the credit market.  Neither TRACERS nor HYDIs exist anymore because the rest of the street saw the potential of those CDS indices and formed the CDX suite of indices to compete with those products which were controlled by Morgan Stanley and JPM.  Many of the “complaints” or issues about the ETF’s are similar to what we saw as CDS indices took off and the “index arb” business grew around that.

I would rather be long HY17 than HYG here.  It has definitely lagged, is a pure spread product, and isn’t trading at a premium.  The ETF’s have lead the market, are trading at a premium, and have a lot of rate risk as many of the high quality bonds are starting to trade more like investment grade bonds.

It is interesting to see both IG17 and Main trading at intrinsic or fair value.  A pretty good indication that the flows there are balanced.  That is consistent with what I’m hearing, in that even so-called “fast money” is more comfortable buying bonds, particularly new issues, than being long via the CDS indices, and at the same time, hedgers are very quiet and after yesterday’s eye-popping move in Italian yields will likely remain quiet to see how strong the LTRO effect is.  There is also a growing fear that we are close to the end of central bank fueled rallies, and investors are definitely nervous about buying into the liquidity rally just as liquidity gets pulled away, and that particularly applies to retail investors.  The hope that they will get chased into the market seems misplaced – the view there seems very skeptical of this market.

Oil remains worth watching, and it is impossible not to watch AAPL.  The ISM number should be interesting after yesterday’s manufacturing miss, as should the factory orders.  In the Eurozone, PMI Manufacturing was 49, unemployment was 10.7%, and year on year CPI and PPI came in at 2.7% and 3.7% respectively.  LTRO may turn things around, but that data fits into a stagflation argument pretty easily.