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What Is the Credit Default Swaps Market Saying About Stocks?


Stocks could go sideways for a while.

This article was originally posted on the Buzz & Banter where subscribers can follow over 30 professional traders as they share their ideas in real time. Want access to the Buzz plus unlimited market commentary? Click here to learn more about MVPRO+.

If one agrees with my thesis that activity in credit default swaps (CDS) has a causal as well as corollary influence on stocks, it is fair to say that the credit bears' latest foray to shake things up has been crushed. 

As I write this, my custom index of large US financials' CDS has fallen below the low end of a range that has lasted several weeks and is making new post-crisis lows. The same goes for the sovereign credit default swaps of Italy and Spain. US credit default swaps are down another 1 bp to 17.5 bps. 

Even China-related credit default swaps -- where credit issues seem to get widespread attention on a daily basis -- are once again lower.

So does that mean that the stock market is ready to break out of the recent trading range?


As I explained in the article referenced above, the tightening of CDS spreads tends to have its biggest short-term impact when it is the results of bears covering the bets laid out during a bear raid. That's because the most efficient way to cover those bets is to go long on equities and equity futures. Once the CDS "short squeeze" is over, that artificial buying pressure fades.

A continued longer-term rise in equities depends mostly on corporations buying back their own stock (much of it funded by the sale of corporate bonds), with the proceeds being rolled into the broader market. You can look here for the data behind this assertion (subscription required).

With earnings season less than two weeks away and a fair amount of pessimism surrounding what those numbers will look like, it's not clear that companies will be willing to crank up the buyback machines just yet. There are also regulatory restrictions on buybacks around earnings announcements.

Don't be surprised if stocks keep churning within the recent range for quite a while longer. That said, with March's $170 billion-plus worth of corporate bond issues highlighting the white-hot state of that market, the chances are far higher than not that eventually, companies will walk their stocks up, market be damned.

Twitter: @FZucchi

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No positions in stocks mentioned.
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