Inconsistent moves in bonds, equities and credit in 2010 have made life very difficult for asset allocators. But is the market throwing up an opportunity to short financials?
At the beginning of the year, the consensus (as I reported from our January Inside ETFs conference at the time) amongst US investors was that it was right to seek inflation protection. Large inflows into TIPS ETFs and ProShares’ Ultrashort Lehman 20+ year Treasury ETF (NYSE Arca: TBT) were testament to this, even if a contrarian mindset might have interpreted such unanimity as a warning sign.
Now, as my colleague Matt Hougan reminded us on Monday, investors in TBT have lost over a quarter of their money in 2010, while some of the world’s best-known investment strategists have ended up with egg on their faces.
For those placing trades on the shape of the US government yield curve, it has also been a tough time. Historical yield spread relationships have been broken (the yield spread of the 30-year US bond over the 10-year hit a new all-time high – 125 basis points – after yesterday’s announcement that the Fed would buy T-bonds but concentrate on those with a maturity of under 10 years).
In Europe, government bond yields have swung all over the place as concerns over sovereign creditworthiness hit a peak in May. For the time being, intra-government credit spread differentials have subsided, although I concur with Satyajit Das, who views Europe’s Financial Stability Facility (EFSF) largely as a debt-shuffling exercise with structural flaws (the lack of joint and several liability) that may even increase the risk of contagion from one country to another.
Equities have been showing directionless volatility. At the time of writing, the S&P futures contract, at just above 1100, is pretty much where it was last October, although in the interim we’ve ranged between 1220 and 1000, with several attempts at establishing a clear bull or bear trend breaking down.
And in credit, the prospect of low official interest rates for some time to come has led to a dramatic inflow of money to corporate bond funds in the search for a bit of incremental income. History tells us that such scrambles for yield invariably end in tears, but so far there’s little sign of investor demand for credit being saturated (as our latest weekly trading report attests).
Or is there? Strategist Tim Backshall of Credit Derivatives Research, which maintains a model comparing credit spreads and equity valuations from a top-down perspective, points out that the credit market has now underperformed equities for six days in a row, sending a possible signal of a trend change.
It is, after all, the credit market that has a successful track record of pinpointing such market reversals, says Backshall.
“The signal from the credit market is clear and has proved right time and again at turning points (whether long or short-term), and that is a slowing of the risk-on rally of the last month or two. The consistency of the last six days’ underperformance (even as last week’s flows maintained decent levels) should be at least pause for thought for tactical asset allocators,” Backshall wrote last night in his excellent daily round-up.
Backshall’s suggestion that investors consider shorting financials’ credit and equities chimes with Pedro de Noronha’s market views, as described on IndexUniverse.eu last week.
If you’re an ETF investor, an obvious way to express such a view would be through db x-trackers’ Stoxx Europe 600 Daily Banks short ETF, or the firm’s short ETFs on the iTraxx Europe senior and subordinated financials index (though bear in mind the problem of return drift if holding such funds for a multiday period); or by shorting a Stoxx Europe 600 bank sector ETF directly (Lyxor, db x-trackers, iShares and Source operate the largest of these funds).