Junk Yard Dog

The equity market has often served as the financial equivalent of a junkyard. Where else can companies like Snap and Blue Apron do an IPO and promptly faceplant after reporting earnings misses? GE cuts its dividend and for its trouble is summarily dispatched to the equity scrap heap. Macy's succumbs to Amazon's onslaught and drops 50%. It seems with every cycle, equity players are hoodwinked into buying their fair share of junk.

Bond market participants have always seen themselves as the junkyard dogs of the financial system. The prototypical bondie has always prided herself on being the sober second thought-police, quickly alerting markets to any deterioration in fundamental soundness that they perceive. Credit markets have a history of sounding the market alarm bells first as they did so spectacularly in 2008.

This past week has seen an abrupt sell-off of the higher risk segment of the bond market, evidenced by the popular ETF, $JNK, experiencing year-high redemptions and a 2.6% drop.

Is this the beginning of the long awaited correction? Is the cycle ending? Do the bond market buzzkillers have some insight that the equity beta hogs are missing?

A necessary precursor to any market cycle ending credit crunch, as I have long been arguing, is an inverted yield curve - an event not currently on the horizon. But there is a significant corroborating event that always accompanies end-of-cycle credit crunches. The tightening of lending standards is always a precursor.

As can be seen in the chart below, lenders typically ask more of debtors in the period leading up to recession-inducing tight money episodes. The increase in lending standards appropriately responds to the stresses detected by loan officers, who have their ear to the ground and are more sensitive to signs of trouble.

Given the fact lenders are still in standards loosening mode, I see no evidence of end-of-cycle behaviours in the credit world.

Percentage of Banks Tightening Standards

What seems to be happening in high yield is most likely technical in nature. Last week, as the treasury curve backed up, risk budgets were reigned in across the world. Credit spreads were at the year's tightest, providing very little valuation wiggle room. With talk of potential credit negative tax policy changes (can the GOP actually get a tax package done??) we were ripe for a small correction.

And what about the explosion in corporate credit issuance? Aren't we stretched thin and vulnerable to a debt collapse?

Remember the main objective of the central bankers over the last ten years: force-feed risk appetite through the monetary system. While we can argue about unintended consequences all we like, their plan has worked, in terms of the financial system. We are flush with equity.

Debt as a Percent of Equity at Market

Is it any wonder the markets can't correct significantly?

The Fed has been spraying the monetary fire hose for so long, they are afraid of shutting the nozzle too quickly. Despite their intention to remove accommodation, they still don't see the systemic risks that would justify aggressive preemptive rate hikes. Signs of credit stress are few and far between. Tight valuation spreads are currently justified, appropriately reflecting the prevailing environment of accelerating growth. With the new Fed chair, Jerome Powell, a copy/paste of Yellen, the markets are unlikely to experience any unsettling change of policy.

So if banks aren't tightening and they see debt/equity levels near thirty year lows, we have little alternative but to roll out the barrel, and party like its 2017!

Year end performance pressure is building, and a beta chase is possible into December after this short term weakness runs its course. But as my friend and ex-colleague, Greg Taylor (PM to the stars!) pointed out to me, watch out for the effect of a tax regime change on the timing of capital gains realization. We could be setting up for a January stumble in the U.S. markets if investors are incented to delay realizing capital gains into the new year.

Just trying to anticipate the anticipations of others for ya!

Risk Model 3:5 - Risk On

The model is saying stay with it for now. We lost the VIX and the RSI is still elevated so so short term hesitation is in order. The overbought is not too worrying unless the vix spike extends.