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The Credit Event: A Graphical Explanation.

  • Written by Syndicated Publisher No Comments Comments
    December 27, 2011

    There has been a lot of talk about equity’s ability to trade independent of credit. That Fed and ECB policy can put  a floor under the equity market and therefore this time “it’s different.” That the US is decoupling from the world once again or that equities can decouple from the currencies.

    The two charts below explain why this is simply not happening and unless the currencies reverse their current trend the equity markets will be faced with a selloff regardless of central bank policy.

    That may sound like a bold statement but when you consider how currencies and equity relate it’s a purely academic statement. The following three simple graphs show how an unabated credit event will eventually become too much for equities.

    Currencies Are Affecting Commodities

    The USD is simply in the middle of a supply demand imbalance. It is going higher until the credit event finds a resolution. The efforts of the FX swap lines three weeks ago and the ECB lending facilities last week have failed to alleviate the demand for the world’s reserve currency.

    As a result the inverse relationship between the dollar and commodities is simply causing a selloff in commodities. For example the DBC commodity index is currently 8% above the October 4 lows compared to the SPX which is 15% above. A week prior DBC was just 1% above the October lows. The following chart is a 3 month daily of DBC VS EUR.

    Commodities Will Affect Equities

    There are those who have said equities can rally without the financials. Now somehow equity is supposed to rally without the commodities? Impossible.  The following chart is a 3 month daily of ES (SPX futures) VS DBC.

    Bottom Line

    Credit is slowly bleeding into equities and unless the EUR and USD reverse their trend this gap will be filled. The following chart is a 3 month daily of ES VS EUR.

    Equities Are Already Breaking Down

    Two charts below show (1) the breakdown in equities and (2) how stretched risk currently is.

    SPX Futures VS Mid Cap Futures – Mid Caps and Small Cap futures are simply failing to move higher with the ES (SPX Futures). Mid Caps lead and they are showing relative weakness right now. The following chart is a six month daily of ES versus EMD (Mid Cap Futures).

    Mid Caps VS 10 Year Yield – At 1.3 beta the Mid Caps represent the greater “speculative” trade than that of SPX with a beta of 1 and the Russell with a beta of 1.17. Contrast that with the 10 year treasury yield the benchmark for no risk and you see just how stretched risk is right here. The following chart is a five year daily of EMD VS TNX (Ten Year Yield).

    Images: Flickr (licence attribution)

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