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Central Bank Dispersion Trading

We live in an age where it makes little sense to evaluate the creditworthiness of a construction company versus a cosmetics company when currency and interest rates moves triggered by central banks telegraph all the action.

What does makes sense in this beautiful and doomed age is a good old-fashioned dispersion trade with a twist of central bank largesse. Short a basket of credit indices, long a single index at leverage.

  • Consider a bucket of credit indices to take out idiosyncratic risks.

  • Construct the bucket such that each index is under the jurisdiction of a different central bank.

  • Buy the index subject to credible and material monetary stimulus.

  • Sell any index where the central bank is tightening.

  • Neutral any index with no material signal.

  • Weight the trade by your blend of central bank resolve/economic weakness.

Have a look at YTD. Note the dynamic: Japan catching a bid all year. US IG is trendless for the latter half of the period. Europe bid on ECB stimulus through late March. Looks like a shift has occurred with Europe selling on the realization that Draghi will not be buying corporate paper any time soon even with Bund and other EU core sovereign bonds yielding ziltch, and Japan keeps the bid on regardless. US investment grade trendless.

YTD: Japan selling protection 3x picked up 60 bps; Itraxx Europe investment grade selling protection 2x picked up 5.08 bps; long US investment grade would have cost -5.47 bps. Net P&L 59.61. Not bad for a market neutral trade in investment grade indices. With real leverage it is money.

Beware. One day we will enter a new age of policy uncertainty where you can’t count on a central bank telegraphing anything meaningful. The way it used to be. Markets will get used to a return to policy uncertainty and refocus on business models, earnings growth, and balance sheets. Unit costs and margins on lipstick will matter.

By the way, I wouldn’t try this out in high yield debt. High yield is always highly idiosyncratic, the indices are apples to mangoes, and the liquidity is not something you want to lever up on.

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