Conor Sen Tracking the Liquidity Trade, (图)

Echoes of 2008? Beware the Ides of August By Conor Sen Aug 19, 2010 11:15 am It's possible with a sovereign catalyst as the trigger for 2010's Lehman event. (0) Comments Share this article: Buzz up! Penny Stocks To Trade Now More by Conor Sen Echoes of 2008? Beware the Ides of August Tracking the Liquidity Trade What's the Buzz? 30 top traders on these stocks and more As I wrote about in Tracking the Liquidity Trade, markets have become more and more correlated and are being driven by changes in aggregate liquidity, which is increasingly a function of the price of the dollar. And the dollar, as we see in the chart below, is increasingly becoming a function of sovereign concerns in Europe. Here's the average spread of the 2-year government yield for the PIIGS countries (minus Greece -- Greece is already being priced for some sort of restructuring) to Germany, along with the DXY index. How does this relate to 2008? In 2008, all markets became a liquidity trade as well. Starting around the time of the Bear Stearns crisis through the end of the year, even intrinsically valuable but illiquid securities (high-quality convertible bonds and investment grade 30-year corporates, for instance) started trading at distressed levels as large banks and insurance funds had no room for them on their balance sheet, at the same time that nobody else had the balance sheet to take them. One of the best ways to track the 2008 crisis at the time was the investment grade CDS index, which hedge funds and fixed-income desks were keying off of but which the institutional equity and retail community wasn't closely following. Investment grade spreads were steadily rising in 2007 before surging in March 2008 during the Bear Stearns takeover. After that spreads cooled off as people thought the worst was behind us -- but spreads never got as low as they did in 2007, and debt levels for Lehman et al never went down. After finding a bottom, spreads began consolidating and headed higher in the summer. This concern wasn't reflected in equity markets, however -- in July and August of 2008 the S&P 500 was marginally positive. It's possible that the same thing is happening this year with PIIGS spreads replacing the IG CDX index as the vehicle(s) to watch. We got the steadily widening spreads beginning the previous year. The surge earlier in the year (early May) coinciding with the flash crash and imminent Greece liquidity concerns. The hastily put together, ill-conceived bailout. Spreads narrowing, but pausing at a higher level. And now spreads beginning to widen out again, all the while equities are trading listlessly. Here's a chart looking at IG CDX spreads between August 2007-August 2008 compared with PIIGS 2-year spreads to Germany (again, without Greece) for August 2009-August 2010. Is a repeat of 2008 possible, with perhaps some sort of sovereign catalyst being the trigger for 2010's Lehman event? That's the big question. But with the VIX trading higher today than it did at the same point in 2008, and with double dip and China slowing fears on people's minds, we can't rule it out -- here's a chart of the VIX between August 2007-October 2008 overlaid with the VIX between August 2009 and today. As we watch the progress of the markets heading into the post-Labor Day period, it helps to have a framework for what's driving price action. We know, for starters, that while the VIX is trading in the mid-20s, implied correlations for S&P 500 (SPX) stocks are at extremely high levels -- Bloomberg's data only go back to November 2008, but correlations around 80 are typically characteristics of markets in free fall, not in trading ranges. It's my assertion that the high correlation among stocks, and among all asset classes, is a function of global liquidity increasingly dominating all price action. To help show this, here's a chart going back to the start of 2009 showing the performance of the S&P 500, the high-yield credit CDX index, and something I'm calling "aggregate M2," or dollar-based M2 of major countries (China, US, Japan, EU, UK mostly). I put a red bar in at the end of September 2009, when stocks and credit began cooling down (since the end of September 2009, the S&P 500 is up just 1.5%), and perhaps not coincidentally, when "organic M2" of the major countries -- that is, M2 in local currency terms -- was slowing. In the chart below, all lines represent year-over-year M2 growth -- the white line is the US, the orange is the EU, the yellow is Japan, and the green is China. With organic M2 crawling along at a 1%-3% pace for the US, Europe, and Japan, and continuing to decelerate for China, what does that mean for aggregate M2, and hence the performance of nearly all global asset prices? It means that it's increasingly a function of the movement in the dollar. As the dollar goes down, European/Japanese (and Chinese when they're allowing their currency to appreciate) M2 buy more in dollar terms. As the dollar goes up, the opposite. And sure enough, since the fourth quarter of last year the relationship between aggregate M2 and the DXY is growing tighter and tighter (aggregate M2 in white, the dollar (inverted) in orange). So that leads to the question of what's driving the dollar. And for the answers to that question, I suggest looking across the Atlantic to the much-maligned PIIGS, which I'll dig into next time.