This CDS report was written by Markit’s Gavan Nolan
The credit markets have been dominated by two events this week, one expected, the other less so. Investors had been preparing for the roll of the CDS indices this week, and the new series’ behaved as anticipated. Spreads are far tighter on all of the major indices, a reflection of the higher credit quality in the underlying constituents. The Markit iTraxx Europe index Series 11 has a smaller weighting of autos, a result of a rule change agreed by Markit and participating dealers. Auto parts suppliers Continental and GKN, the former trading upfront and the latter around 750bp, have been removed and replaced by solid investment grade names such as Rolls Royce and Solvay. Several car makers have also been removed. Investors seeking exposure to the ailing auto sector may decide to refrain from rolling into the new contract.
The effect of the roll on the Markit iTraxx Crossover index was even more noticeable. The index is now trading well below 1,000bp and is at its tightest level since late November. Credits in serious distress, such as Ineos and ONO Finance, have been removed and been replaced by fallen angels trading well below 1,000bp like Clariant and Renault. That said, around half of the Xover constituents in Series 11 are trading upfront and it is likely to continue to underperform relative to Main and stock indices.
In the US the picture was much the same. Indices tightened significantly, with the Markit CDX IG trading below 200bp for the first time since the beginning of the year. The removal of several high-beta names and the inclusion of names with strong credit profiles, such as AAA Pfizer, pushed spreads tighter. However, like Europe, the underlying market was moderately wider, tracking a lacklustre stock market. Previous indices moved wider, though technical flows may have played a part.
So much for the index rolls. But the US Federal Reserve ensured that credit investors faced a week that was anything but predictable. It surprised investors on Wednesday by announcing a massive programme of quantitative easing. The central bank will buy $300 of US government debt and increase its purchases of securities issued by agencies Fannie Mae and Freddie Mac. However, the reaction of the markets was all too familiar. After the radical action triggered a rally, stocks and spreads fell back. Previous rallies prompted by state action have also proved ephemeral.
But the underlying reasons behind the current sell-off are less clear. Doubts that governments are capable of resuscitating the banking system and the broader economy lay behind much of the pessimism in previous months. This is still a factor. The Fed measures will increase the broad money supply, which should lower long-term interest rates and make it easier for banks to lend. But it has become clear that the transmission mechanism from the central bank to the private credit markets is not functioning correctly, and the Fed measures will not be effective if banks decide to hoard cash.
Many investors, however, feel that the aggressive Fed policy will be all too effective. If the stimulus works and the output gap closes, then interest rates will have to rise to combat inflation engendered by excess money. Skepticism that the authorities will act when needed – memories of the Greenspan era and the housing bubble are still fresh – has raised inflation expectations. Traditional hedges against price level rises, such as gold and silver, have seen an influx of capital after the Fed announcement. Oil has also risen. The price of crude is now at its highest level since November. Oil and gas credits have outperformed relative to other sectors, particularly industrials. Several firms in the manufacturing industries have issued profit warnings recently, a reminder that the problems are grave and not just an academic debate between economists.