Monday July 10

US stocks started out the week fractionally higher on follow through optimism after the NFP report and ahead of 2Q earnings releases later this week. The S&P 500 rose 0.1% to 2,427 and the Dow Jones fell fractionally to 21,408. The KBW Bank index and the DJ Utility Average each fell less than 0.1% to start the week. Economic data today was light, however it is a busy week for Fedspeak with comments forthcoming from Lael Brainard, Neel Kashkari, Janet Yellen, Esther George, Charles Evans, Robert Kaplan, and John Williams. Additionally Janet Yellen is going to testify in front of Congress where she will likely defend the manner in which the Fed conducts monetary policy. Also on the economic calendar this week is PPI, CPI, retail sales, and industrial production data. It was a quiet day in financial markets today, but the global bond selloff did recover somewhat. The 2 year Treasury yield fell 1bp to 1.39%. The 10 year Treasury yield fell 1bp as well to 2.38%. Accordingly 2yr vs 10yr finished at 0.99%. 10 year yields in Germany and the UK fell 4bp to 0.54% and 1.27% respectively. USD rose slightly against peers. USD rose marginally against EUR to $1.1397. USD rose 0.2% against JPY to Y114.05. USD rose 0.1% against GBP to $1.2880. Oil started the week tentatively higher. WTI rose 0.8% to $44.56. Brent rose 0.7% to $47.03.

Hedge funds are seeking to profit by “orphaning” outstanding CDS contracts against debt issued by Matalan. Matalan is a European retailer that currently is rated CCC, and its bonds trade at yields around 11%. Hedge funds sold CDS against outstanding Matalan bonds when CDS spreads were very high, believed to be around $4mm for every $10mm in notional principal, or 4000 basis points. Now those same hedge funds want to help Matalan refinance the debt that the funds are short. They hope Matalan will refinance the debt by issuing the bonds under a separate legal entity, which would not be covered under the CDS the hedge funds sold. That would make the CDS that they sold effectively worthless as the legal entity that formerly housed debt would have no debt anymore, and the CDS contracts that they sold would expire worthless. That process is known as “orphaning” the outstanding CDS. The key risk for the hedge funds here is that Matalan defaults on the refinancing issue in the event that the hedge funds retain the deal. There is also legal risk.  This type of activity was more common before the financial crisis when the single name CDS market was more liquid. In 2006 the SEC investigated an insider trading case involving a deal similar to this with a Dutch company, however it was dismissed in 2010.

Investor focus on what the next monetary policy move is shifting from the Fed towards the ECB. Over the last few years investors would hang on the Fed’s every word to determine how the Fed may adjust monetary policy, and interpretations from statements would drive global financial markets. Now that is shifting from the Fed to the ECB. The Fed is underway with a tightening cycle, and it has discussed plans to begin unwinding the balance sheet within the next few months. In the past such steps might have rattled markets, however this past month the rate hike and the announcement to unwind the balance sheet went smoothly in markets. In Europe on the other hand, investors are hanging on Mario Draghi’s every word and that is driving market activity in both the US and in Europe. The ECB currently buys EUR 60bn of bonds each month, which equates to around EUR 2bn per day. That has pushed down yields and increased asset prices. Financial markets in the US have benefitted as well as investors dissatisfied with depressed yields in the eurozone look to the US for higher returns. Since 2012 US corporate bonds held by foreign private investors have steadily increased from around $2.5tn to $3.5tn. US Treasuries held by foreign private investors have increased from $1tn to just under $2tn over that same time span. As the ECB looks to normalize policy in Europe, some international investors might take money out of the US and put it back to work in Europe as rates rise. If the ECB begins to raise rates, it could reduce pressure on the dollar as well. The dollar experienced upward pressure as a result of monetary policy divergence between the US and Europe, however as both countries shift towards a tightening bias it could take some pressure off the dollar.

As ETFs become a more mature and popular asset class there are still ways investors can use them more effectively. One of the easiest ways investors can do so is to time the purchase so that it does not coincide with the market open or market close. Typically ETF NAV’s tend to diverge from the value of the underlying assets at the market open and close due to a flurry of orders and heightened volatility. That means that investors can reduce transaction costs and more effectively track the portfolio they want exposure to by buying ETFs during times when the NAV most accurately tracks the assets. Another way investors can use ETFs more effectively is to understand the nature of funds that are marketed as “smart beta” or similar nomenclature. These funds use certain factors, other than market cap, to weight its holdings in order to achieve outperformance based on those factors. For example a dividend smart beta fund might hold stocks that pay high dividends with a higher capitalization than they are held in a cap weighted index. A problem with those types of funds is that specific factors go in and out of style with respect to how they perform against the market. As one factor gets overplayed, the price of the stocks will get expensive leading to underperformance. In that way smart beta funds may not be the best strategy for a longer term investment horizon. Investors should also be cognizant of funds that use complex beta strategies or combine multiple factors. Some complex ETFs use as many as 15 or 20 factors in its strategy. Regardless investors should be well aware of how each ETF in their portfolio will perform in certain market environments.

Monday July 10

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