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Corporate Bonds, Derivatives, and How They Wag the Equity Markets

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To more accurately guess the primary direction of equity markets, there are better places to look to than stocks themselves.

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Next, we must worry about what could throw the corporate bond market off its tracks.

The risks are only limited by your imagination, but my two primary concerns are the obvious ones: Number one, China, and number two, Europe. I won't spend any time on these because there's certainly no lack of discussion on the topics. I will point out, however, that some analysts (Brian Reynolds among them) are of the view that these kinds of exogenous concerns can temporarily influence the US corporate bond market, but are unlikely to be the catalyst for the end of the current credit boom.

I tend to disagree for two main reasons.

First, the only tool available to Europe to try to keep things from unraveling is the printing of fiat money, which entails confidence on the part of the recipients of this currency that it is indeed worth its stated value. By definition, printing of fiat money dilutes confidence, so what's holding Europe together now is also laying the foundation for its demise. (The same can be said about the US, of course.)

Second, problems in Europe and/or China risk the worsening of "societal acrimony" to a point where, in lesser stable areas, it can flare into violence rather quickly. If that happens, all bets are off.

So how do I track the ups and down of China and Europe?

China's official data is a sketchy as it is unreliable; as a "command and control" economy, there is nothing that the government can't manipulate. I find the most useful information to be anecdotal. Images of ghost cities built for millions of people, and empty office towers with enough space for a 100-square-foot office for every man, woman, and child is about all I need to know about China's "economic miracle."

Tracking Europe is easier. Aside from the generally available economic data, sovereign CDS and bond spreads speak volumes on the ebb and flow of confidence vis-à-vis specific countries and the euro currency as a whole. Bottom up, the countries currently in focus are Italy and Spain (but I am not ignoring Greece, Portugal, and France), so those are the most important 10-year bond rates to watch. I find it more relevant to focus on levels rather than the daily up and down moves. For example, the 7.50% area on the Spanish 10-year is where the ECB last freaked out and verbally "intervened."

A similar level for Italy would be the 6.50% area. Should yields blow through those rates, not only would it make it prohibitively expensive for the countries to service their debts, but it would signal a broader collapse in confidence and an increase in systemic risk. Currently, the Spanish 10-year trades around 6.5% and the Italian 10-year trades around 5.8%. Neither country can bear these rates long term, but they are buying time to figure out a solution (if there is one). Conversely, the German 10-year yield is a reliable indicator of "flight to quality." At 1.34%, it's pretty close to the 1.2% area, which might trigger an even deeper crisis in Europe.

Positions in SPX
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