Today's Tidbits

Risk Aversion May Cause Higher Volatility, Reduced Correlation & Steeper Curve
From Morgan Stanley: “The market is in a risk aversion mode and the steps it takes to reduce risk may cause volatility to rise and correlations to fall. It would be naïve to think that the market mean-reverts back to the way things were just prior to the meltdown in
subprime. In fact, we view the recent event in subprime as a big bang, of sorts, that catalyzes a reversal in excessive risk-taking over the past several years. This would lead to a breakdown in the current high levels of market correlations. We call this a ReNormalization…This is significant because it marks a reversal of risk dynamics that we have grown accustomed to over the past few years…Too much liquidity and leverage chasing too few assets creates not only an increase in asset inflation but also an increase in asset correlation. In a world of easy money, liquidity and leverage can be manufactured quite easily and viewed as commodities. In this world lenders of capital compete aggressively with one another. This competition drives lenders of capital further down the quality spectrum to make more risky loans to achieve incrementally less returns. In turn, investors also move down the quality spectrum as the supply of investible assets dwindles. Soon, neither borrower nor lender fully differentiates risks inter- and intra-asset class. Effectively, assets move more closely together and volatility declines. This drives correlations higher. But it cuts both ways. This is because the mechanism from lenders of capital (prime brokerage, credit lines, repos, etc.) starts to tighten lending standards for the users of capital. For example, larger ‘hair-cuts’ on collateral may be required today in reflection of the increase in volatility and market uncertainty. Effectively, this makes the ease of acquiring liquidity and leverage more difficult and more costly. In turn, investor demand for assets declines and investors become more discerning about the risk they are taking. Soon, both borrowers and lenders start to differentiate risks inter- and intra-asset class. Effectively, assets move less closely together and volatility rises. This drives correlations lower…We argue that the historically flat level of the yield curve remains as one of the greatest dislocations across the rates market…We think the timing is ripe to position for a steeper yield curve, higher volatility and a breakdown in correlations.”

Impact of VAR [Estimated Value-at-Risk] on Market Participants
From NATIXIS: “Ultimately, the market was able to hold the line for less than a day, with equities closing on 3.5 month lows and bonds reversing all of yesterday’s decline and then some. I wonder how much of the failure was due to tighter risk budgets. Readers who aren’t familiar with sell-side risk limits may not be aware of the tyranny of VAR-based risk budgeting. Value-at-risk (VAR) methodologies at their core involve certain assumptions about market volatilities and correlations. Some models use historical volatilities, some use model volatilities, but for all of them VAR rises when (a) volatility rises and (b) correlations increase. Not too unlike a CDO tranche, actually. So in times when market volatility is creating great opportunity, the sell-side loses some of its ability to take on risk since the same positions now consume more of the VAR budget. The buy side typically has looser constraints (which is why some of them blow up), which means that in times of volatility the “fast money” becomes more and more dominant over flows.
Dealers hate that, but there is nothing they can do about it. When volatilities and/or correlations recede, then risk budgets will be resuscitated but in the meantime, the market stabilizers are decidedly less stable.”

Credit Default Swaps Display Signs of Immaturity and Inefficiency
From The Financial Times: “Did the risk of default on US investment grade bonds really triple over the past month? And, having done so, did this risk really drop by a third over the ensuing 24 hours? Of course not. But movements in the prices of credit default swaps, which allow investors to buy protection against defaults, suggested exactly that. So we now know that the market for credit derivatives, which did not exist five years ago, is inefficient… The way the price of default swaps has ricocheted in the past few days appears to reflect a market in which there are only a few ultimate "sellers" (at the big investment banks), who, if they do not feel confident about their ability to hedge their exposures, can simply mark prices up to unrealistic levels. This is much less efficient than the markets for stocks or bonds. As for the fundamentals, moves in swaps prices have far outpaced moves in underlying bonds.”

MISC
From RBSGC: “As badly as investors want to believe that the worst of it is behind us, global financial markets remain in turmoil and certainly more pain exists on the horizon…Credit markets are seizing up as global markets reprice risk premiums across all asset classes. While pass-throughs are AAA and relatively liquid compared to some of the securities out there, the market appetite for risk is minimal and unlikely to change soon. Mortgages however are the tail, not the dog right now and valuations will simply be a function of treasuries, swaps and implied volatility until further notice. We are keeping our powder dry and waiting for friendlier price action before committing capital to a significant trade. Mortgages are very cheap but difficult to hedge. Bid/ask spreads are widening to reflect the illiquidity and only are going to get worse for the time being.”

From Merrill Lynch: “…just about every currency is losing ground to the yen…”

From UBS: “Agencies underperformed Treasuries and swaps across the curve over the past 2 weeks as the mortgage market, hedge funds and the equity market decline contributed to the suffering. During the past 3 trading sessions Agencies appear to be turning the corner, and spreads are inching back in…”
From Forbes: “Standard & Poor's said the U.S. corporate bond market was officially speculative grade. The big ratings agency said 50.7% of the corporate bond market is now rated speculative grade, the first time this has happened, marking a decade-long shift toward more aggressive finance strategies and the evolution of the leveraged finance market. S&P calls anything below BBB- "speculative," but most people just call it junk. These days, the market calls it scary.”
From Bloomberg: “Crude-oil supplies dropped 6.5 million barrels in the week ended July 27, the biggest decline this year, according to the department. Gasoline, diesel and heating-oil stockpiles rose as refiners bolstered operating rates to 93.6 percent of capacity, the highest in 13 months.”
From JP Morgan: “Pending home sales surged 5% in June, a surprising move given the rise in mortgage rates in that month and tightening lending standards. However, this rise should be viewed in the context of declines in the prior three months: a cumulative 11.1%. Moreover, mortgage interest rates were up measurably between May and June, while builder assessments of sales and new home sales pulled back sharply. These developments question the credibility of the 5% jump reported today.”

From JP Morgan: “The JPMorgan global manufacturing PMI suffered a setback in July, all but reversing the impressive uptrend since the turn of the year. The headline composite index sank 1.3 point to 53.1 in July, its largest fall since March of 2003. The sharp fall was broadly-based across the PMI’s components, including output, new orders, export orders, and employment. The particularly large fall in the output index was the second biggest decline in the history of the survey back to 1998, excluding the drop following the 9/11 terrorist attacks, and points to an easing in the growth of industrial activity last month. The level of the PMI remains solid, but the drop may indicate renewed concern among businesses regarding the pace of aggregate demand in the second half of this year.”

From Merrill Lynch: “…it is clear that: business capex and consumer spending growth, and inventory stockpiling have decelerated at the beginning of 3Q-07, and these are the factors behind the decelerating dynamic in real GDP growth and in ISM.”

From The Financial Times: “The spat between the US and China over contaminated food exports highlights a rapidly spreading battle line in the world economy: the use of product standards to regulate, and some would say stifle, international trade.”
The Financial Times: “The world's biggest oil prod-ucers have boosted their search for oil and gas to one of the highest levels in two decades as prices yesterday neared record highs of more than $78 a barrel. The Organisation of the Petroleum Exporting Countries, the cartel that controls three-quarters of global oil reserves, said yesterday that its members operated 336 oil rigs last year, an increase of 11.5 per cent since 2005, in response to strong demand from developing countries such as China and India… Saudi Arabia drilled 382 new wells last year, the highest number for any year since 1980.”