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


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


Moves in sovereigns' CDS are also a general precursor to swings in the underlying bonds, partly because they insure those bonds, but also because CDS offer macro funds a leveraged way to express directional positions. I've put together my own little index of CDS, which includes both shaky nations as well as Germany. You can see from the chart below that in the aggregate CDS, levels are higher than pre-2008 crisis, but well off the highs, and they are generally stable.

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So, in the aggregate, EU bonds and CDS don't look healthy nor do they look terminal.

Of course, the EU spasms concern us only to the extent that they impact our financial system or our economy. To monitor if that is happening, I track an index of CDS on bonds of large US financial companies. Our big banks -- JPMorgan (JPM), Morgan Stanley (MS), Goldman Sachs (GS), Bank of America (BAC), etc. -- is where EU problems would metastasize first. Of course, these CDS would also warn us of any renewed "homegrown issues." Broader non-financial CDS indices such at the Markit CDX.IG 18 can also add color. As you can see below, things remain boringly steady for now.

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Lastly, the two-year swap spread and CDS on US debt represent the "contagion warning system." While at times macro players have attempted to mess with US CDS just to spook the markets, bona fide spikes have occurred only during times of true stress, and have been concurrent with jumps in the two-year swap spread. When these two measures start "misbehaving," they tend to signal that not only are there stresses within our financial system, but those stresses have the potential to become systemic. As one may predict by glancing at our "boring" big financials' CDS, US CDS show no signs of concern and two-year swaps are trading remarkably tight.

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