With an excess demand for risk in the air and stocks continuing to climb a Brexit wall of worry higher, Bank of America Merrill Lynch (in a note titled “Excess demand for risk”) has a relative value trade it thinks institutional investors should consider.

BAML 7 14 TNX SPX spread risk

Significant credit / equity spread dispersion as panic is subsiding

Fear, even if it is manufactured, is a valuable indicator in trading. When one can identify the establishment meme that ignores key facts on the other side and recognize that two-sided discussion was muted, for some this is a trade trigger alert.

BAML’s Hans Mikkelsen might not have been thinking these thoughts before Brexit, but now in the aftermath where serious issues still exist emerges a trade thesis.

Credit spreads are displaying a relative value dispersion, he notes. This is particularly true in the center of Brexit fear.  Consider how high quality credit was tight before the Brexit vote and then look at it now. The markets have panicked and now reverted. In fact, some have exceeded pre-Brexit levels, sending trade trigger messages:

Our HG index tightened 3bps to 152bps, which is 2bps better than pre-Brexit. Not surprisingly HY outperformed with our index tightening 20bps to 646bps, or 37bps tighter than the day before Brexit. Even EUR credit is now trading at higher valuations than before the UK decided to exit (124bps now vs. 126bps on 6/23 for HG). The Sterling corporate credit market has still widened post-Brexit, but at 176bps currently only by 5bps.

Are treasuries mean reverting and now correlating with stocks?

But looking inward at the US stock market, which hasn’t been impacted by Brexit to nearly the same degree, Mikkelsen notes a value dispersion. Equities have been climbing significantly higher while the Ten Year Treasury Yield has diverged. The correlation has started to correct only recently.

After reaching a low of 1.37% on July 8, the market since jumped to 1.53% today. The Brexit panic pushed yields down from 1.69% on June 23 to the recent 1.37% lows as scared investors rushed to the relative safety of US Treasuries.

Looking at the price action, Mikkelsen considers market environment and then makes a trade recommendation. “Such market environment is perfect for credit spreads with consumer names another 0-4bps tighter, pharma 2-5bps tighter, autos 5-8bps tighter and energy 3- 20bps tighter on a day where oil prices were up 4.6%.”

But it’s not just these stocks he was recommending in the report under the banner headline of “Excess demand for risk.”  He also likes the beaten down banks. “We think that the present environment is so strong that current bank spreads present attractive entry levels for long positions – even with supply.”

The looming bank bailout in Italy and Europe was not mentioned in the analysis reviewed by ValueWalk.