While the mainstream focus continues to be on stocks, which will probably always be the case, there are perhaps more important factors to consider in other “risky” places. The burst of buying in UST’s yesterday was not done in a vacuum and I don’t believe it was related to the simplistic idea of stock investor “rotation.” In fact, when you look at the behavior of those “risk” parts of the credit markets, the jerk at the open in UST had all the telltale signs of collateral calls (both given and impending). What should be a very big warning was the effect of those accumulated against a rather shaky and illiquid “market” (thank you very much, QE).

There is no way to be sure the exact nature of the readjustments, haircuts or whatnot, but the massive imbalance right at the open was, again, I think pretty indicative of something like that. We don’t have to look very far to find the culprits, either.

ABOOK Oct 2014 Leveraged Index 100

We know all too well that the “quality” of risky corporate credit has deteriorated despite the “best efforts” (utterly absurd, more specifically) of Janet Yellen’s new savior in macroprudential policy. Using S&P’s index for the 100 most liquid leveraged loan pieces, that quality took a bit of a turn recently – so much that the index has fallen despite the steady buildup of interest payments (and very few defaults overall; none that I am aware in the index).

ABOOK Oct 2014 Leveraged Index Peak

In what should be of no surprise, the index value peaked right in that first week in July as the “dollar” began to grow short once more. However, if we strip away the interest side and focus just on leveraged loan prices, the actual behavior fits right into recent events with very little ambiguity.

ABOOK Oct 2014 Leveraged Index Mkt Val

Market values in leveraged loans (at least if the index is a fair proxy, and it is very likely that less liquid leveraged loan “products” fared with a much higher beta) since the dollar turn have been beaten far worse than during 2013’s major global selloff. So much so, that the prices here in the index are now well below when QE3 even began.

ABOOK Oct 2014 Leveraged Index Mkt Val below QE

Putting that all in perspective, the systemic behavior here is quite remarkable. A 3% decline of late is really not all that much going back to the last cycle peak. In 2011, the market value of leveraged loans in the index declined about 7.5% during the illiquidity related to euro concerns. In the first months of 2008, market values dropped almost 9%. And, of course, during the “main event” of total panic and illiquidity starting with Lehman, leveraged loan prices collapsed by a third (which is still amazing to see even with that context in mind).

So the latest selloff, as it stands now, is seemingly but a minor interruption not especially worthy of comment outside of how it sticks out against recent placidity. However, that is the point – that I believe there was a connection between this “minor” price inflection and the major disruption in liquidity and UST’s lately. That, to me, demonstrates a potential scale for how seriously devolved systemic function has become.

Some of that is simple complacency being rudely interjected, as you can see in the charts above for market value. Whenever anything attains such seeming stability there is a very human (and mathematical, given recency bias in all statistics) tendency to let down any guard or skepticism. I don’t think there is any doubt that a lot of that related to QE3 and QE4 and how participants viewed “tail risk” (or actual loss projections) with the Fed so “committed” (even though they committed to really nothing but letting market agents fool themselves into thinking that).

But there seems to be a little bit more to it in order to explain, for me, the totality of the past few weeks. I think that part can be seen by the now divergence between the global dollar short which started all this in July and the behavior of these “markets” in October. As I noted yesterday, eurodollars have quite visible and substantially reversed since the end of September.

ABOOK Oct 2014 Eurodollars

Yet, during that period credit markets have remained under the same duress, breaking wide open yesterday despite much better “dollar” conditions. I think the correlation breakdown between HYG and REM (high yield debt prices in retail terms against mortgage REIT prices which are a pretty fair representation of systemic liquidity) is revealing in that regard.

ABOOK Oct 2014 Leveraged HYG REM

For the most part, REM has moved up and down with the inner part of the eurodollar curve, especially in October. Yet, despite that improvement (and that is certainly an arguable point, since “improvement” here is, at best, a relative term) HYG was hammered yet again – very much like leveraged loans.

Liquidity is only part of the equation, if indeed the central part, meaning that positioning based on artificial expectations surrounding QE may have to be (further) drastically rethought. In other words, liquidity kicked it all off, but now credit concerns and actual default risk at something more than historically low levels begin to creep into expectations (again, both human thinking and mathematical models that are no longer so captured and downwardly skewed by this perhaps formerly self-feeding process). So the actual level of price change, lower, is maybe minor in historical comparison but amplified by the nature of QE artificiality running down quickly toward zero. Such asymmetry is the problem.