Is Derisking Coming Up?

In compiling a lot of recent headlines, I'm getting the inclination that markets are poised to derisk by the end of this quarter. I was working through an article about CALPERS, who released a memo Thursday -- something to the effect of reducing High Yield allocations with PIMCO and Alliance Bernstein (AB):

Because the significant rally in corporate credit is most likely done, reducing exposure to AB... is justified.

Staff is reducing exposure to PIMCO... but recommends renewing the contract and allocating more assets to PIMCO in the future when risk aversion is expected to produce alpha in the high yield market.

That's about $450mm (redemption from Alliance Bernstein) plus $100mm (from PIMCO) worth of HY that'll be fishing for a bid... a drop of water in the ocean, but a worthwhile note nonetheless.

I compound that with the following slew of spread-widening considerations:

1. The Fed has now ceased its Permanant Open Market Operations (POMO) in purchasing Treasuries.
2. The Fed's balance sheet has started shrinking after repeatedly finding its upward limit.
3. The US trade deficit [get this] widened in the past month. By virtue of commodity price appreciation, a weak US Dollar actually managed to offset the expected increase in October exports with costly imports (esp. oil and raw materials). With the USD carry-trade fully inflated AND political tempers flaring, the USD's dive should find temporary reprive. [As an aside, imports picked up because industry tried to make a return in October, hence the oil and raw material inflows. Are we now stuck in purgatory, between a Stock Market that needs a weak USD to move and an Economy that needs imports to operate? Interesting to see how this plays out... could it be the impetus Alternative Energy is looking for?]

There's a more lot at work to add to that mix (feel free to use the Comments section as a forum for more discussion), but like I said, this is a quick note. Now, while none of those tidbits are direct hits upon HY fixed income and other risky assets, you have to understand the mechanics of what's happened in this broad rally...

Namely, liquidity gushed into the economy. The rally started with a pursuit of quality, which had already been the vogue trade since Lehman's collapse. A persistent, relentless stream of liquidity had an excess of capital chasing a dearth of quality. In the deflationary environment we were in, capital had to be allocated out of (floating rate) cash instruments to avoid negative-interest erosion, so the rally in quality spilled over into riskier and riskier assets:

You can see the decoupling of Investment Grade and High Yield in October 2008 after LEH. After that period of decoupling, spreads have narrowed (as evidenced in the rally since March)--in true form to the generally accepted "9 month lag on monetary policy" and the steep increases to the M2 Money Stock between LEH & March. The even more dramatic spillout into even riskier grades (Equities) is manifest in the chart below:

Considering the aforementioned policy lag, I count out 8-9 months from December 08 on the M2 curve (where we see a flattening in the first liquidity ramp-up) and the rally in Equities stalls. Counting out from the March pinnacle of M2 would indicate that another stall should be in store for this coming December. [You may also note that--without a lag--any flat period of M2 stagnation is coupled with Equity gains... particularly echoed in the period from March to present. I wonder if liquidity is being redirected into securities? /sarcasm.]

With everyone and their brother putting up good numbers this year, there's a strong case for a spread-widening derisking through the end of 2009.