As Cool as Carl

By Kevin Muir of the Macro Tourist

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I know all the cool kids like to quote Nassim Taleb and give dire warnings about the coming collapse of risk assets, but I must have too many years of playing Dungeons & Dragons because I just can’t seem to join their club. I don’t see the same black swans that everyone else does. Central Banks have gone giant-golden-crowned-flying-fox batshit crazy, and instead of looking at the possibility that this unprecedented science experiment explodes in a fiery inflationary explosion to the upside, the “in-crowd” are all convinced the collapse has to look exactly like 2008 (only worse).

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And yeah, there is no doubt that given the stretched valuations in risk assets, a Central Bank tightening error might have catastrophic consequences. Yet, I believe there is at least an equal chance that Central Bankers have made (or will make) a colossal overshoot error. You are probably getting bored with my posting of the chart of Central Bank balance sheets, but I am amazed at how these Central Bankers can write billions of dollars of blue tickets, and we don’t bat an eye.

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The Swiss National Bank owns $85 billion of US equities. F’ me. That’s just absurd.

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Central Banks are printing money out of thin air and buying stocks with it. Stop a moment and really take that in. Short term interest rates are negative in many parts of the developed world. Negative! How do you price equities with negative interest rates and Central Banks competing with blue tickets?

But hey! What do I know? Maybe all this extreme monetary stimulus means that when the business cycle finally kicks in, the fall will be all the more violent. That’s certainly the prevalent thinking amongst the “cool kids.”

And while a good portion of this crowd is busy buying VIX and shorting stocks, the more sophisticated are buying protection on corporate bonds. This trade has much less negative carry and presents a much better asymmetrical risk reward profile. Corporate bonds can, at best, only return the interest, but can lose the whole principal.

So when a trader looks at the current high yield spread on the 10 year CSI Barclays index, which is trading at 361 basis points, it seems like betting against corporate bonds is a cheap wager. After all, if they are wrong, it costs less than 4% a year. But if they are correct, then this spread could easily double to 8% like 2015 and 2011, or even spike to 20% like 2008!

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This trade made legends of the few hedge fund gurus who were long CDX protection during the Great Financial Crisis. And since this huge win is embedded in all the hedgies’ minds, everyone now envisions themselves putting on the next Big Short.

Carl Icahn even went so far to make a video, fittingly named “Danger Ahead,” outlining the disaster that is coming in high yield bonds.

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In the video, Carl highlights how he is buying protection on high yield bonds anticipating rising defaults and spreads blowing out. The problem for all of us without ISDAs, this trade is out of reach. Sure we could short the HYG ETF and buy government bonds in some form on the other side, but this is not a capital efficient way to put on the trade.

What is needed is a listed derivative instrument that tracks the high yield spread index. And I thought we were out luck until I received a call from Corry at ICE Futures. Much to my surprise, ICE has a couple of contracts based on Markit’s CDX Investment Grade (IG) and High Yield (HY) indexes. I could barely contain my excitement. This sort of product is perfectly suited for traders that either don’t have access to OTC products, or want the benefits of trading a listed product.

Corry sent me a PDF with the products’ details. I uploaded it and you can download it here. Or alternatively, you can navigate to the ICE website to the credit index section.

Now I realize that these futures contracts are still in their infancy. There is not a ton of open interest, and the volume is small. Yet there are market makers continually providing decent two sided markets. And most importantly, the underlying index that the future expires into are OTC benchmarks.

All of a sudden, you can be just as cool as Carl Icahn, and buy protection on the CDX HY CDSI S28 5Y swap.

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There is one slight problem for us Interactive Brokers users – IB has not yet listed the product. Corry says it is in the works, but if you are an IB client that wants to trade it, then a request from more clients would probably help speed the process along.

Although I have no desire to join the cool kids and get long CDX protection, I know that many of you have asked for efficient way to put this trade on. Now there is a product that levels the playing field for the little guy. It is in all of our interest that this product succeed. Who knows, someday I might be cool enough to leave the geek table in the cafeteria, and I would love for there to be liquid listed CDX products to trade.

In the mean time, I will agree with Carl that high yield bonds are a disaster in the making. But where I differ is that I believe all fixed income will be a problem. Carl is convinced that credit will be the epic center of pain for the next crisis. I think duration risk is by far more worrisome. I, therefore, have no desire to short high yield credit and go long government bonds (which is what the CDX swap tracks).

But it’s great to know that you can climb aboard Carl’s train, and get long CDX protection. Just be careful you don’t make Carl mad – you don’t want him yelling at you -it’s not pretty.

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