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FT Alphaville » Beware the quant models
If you thought the headlines were bearish… you haven’t seen the bank quant models (the ones which presumably can’t read headlines).
Looking at SocGen’s latest cross asset quant research, the picture painted on all signal fronts is increasingly coming across on the dire side:
* This note sums up a number of signals, mostly tactical in nature, which have been highlighted by our range of models.
*Our Sentiment Indicator dropped to almost zero one week ago, and has failed to pick up.
*Implied volatility looks low overall, especially against credit spreads. The options market is split. Some assets trade at a significant premium against realised volatility, with safe havens like gold, JPY and USD rates left out with a low implied volatility.
*Our x-asset Top-Down model is bearish on the euro and the British pound, and bullish on the Japanese yen. Gold has strong upside potential, while our model remains bearish on oil and expects USD and EUR inflation breakevens to come down. We also look at opportunities in EM FX.
*The EUR swap curve has flattened dramatically. Our tactical model identifies an opportunity to receive a 2s5s10s barbell. We also apply our macro finance model to the UK economy, and expect the GBP swap curve to flatten. We also look at the AUD curve vs. GBP.
*In credit, we estimate that corporate bonds look overvalued against CDS, and would buy protection on the iTraxx Xover.
And here’s a bit more about that sinking sentiment indicator:
For a start, our Sentiment Indicator almost dropped to almost zero one week ago, and has failed to pick up. The extent and consistency of this move suggest taking this signal seriously, and staying away from long risk positions for the moment.
Another cause for concern is that credit spreads are very wide. We looked at possible dislocations between CDS spreads and share prices of individual companies, and found no reason to expect credit spreads to tighten any time soon.
As highlighted by our x-asset volatility monitor, implied volatility looks surprisingly low overall. So, investors can take a strong bearish view and buy volatility outright.
Realised volatility has remained relatively low, which is holding implied volatility down compared to credit spreads. In order to offset the cost of buying options, we look at discrepancies across assets, with options on safe havens, such as gold, the Japanese yen and USD swaps, appearing very cheap.
Here’s another interesting spot from the team.
When it comes to European CDS, the analysts note that the market has underperformed the bond market since the beginning of the bearish momentum at the end of March. The so-called “basis” — the difference between CDS and bonds in bps — is now at about 72bp, a historical high.
They have two possible explanations for these very positive basis:
* First, the bond market has been more stable than the CDS market since the beginning of the sovereign crisis. CDS are actively used to trade risk, while bond buyers tend to hold on to their investments. In a downturn or a liquidity crisis, panicked bond investors may sell off. The basis becomes significantly negative, as it did after the default of Lehman Brothers. This time, however, the bond market has stood firm, which brings us to our next point.
*Second, bund yields are very low, which encourages the risk appetite of portfolio managers on other assets in the cash market to maintain a certain level of yields.
The analysts also note that since the first Greek bailout, the basis between CDS and bonds has been well correlated with German bunds as measured against swaps. The correlation reached -77 per cent over that period, indicating corporate bonds were also benefiting from “safe haven” status.
But now even this correlation has been surpassed. As SocGen notes:
…even the richness of German bunds fails to fully explain the extent of the basis. We estimate that bonds offer an excess premium of at least 30bp against CDS, on average.
And eye-catching chart that’s for sure.
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