Last week appears to have been a good one for US credit markets even if data suggest all is far from well in the financial world, according to a slew of recent research notes.
Analysts at Moody’s Capital Markets Research Group (CMRG) described this situation as a “mud thaw”:
Akin to the feeling that warmer weather is around the corner after a long hard winter, equity markets have been rising and credit spreads narrowing. Yet the melting snow is mixing with thawing earth to create a muddy murky mess
This murky mess is the result of a some positive headline numbers – like recent record high-yield debt issuance and a 4.5 per cent decline in speculative-grade spreads – mixed with a spike in the default rate and plunging recovery values.
Moreover, per CMRG, economic data has also been mixed, at best:
Core CPI held steady at 0.2% per month for the third month in a row indicating that most service and commodity prices are not deflating. The beige book report provided hints of stabilization, even while US housing permits hit record lows. The VIX index of S&P 500 equity option volatility (commonly knowthe “fear index”) has declined from over 42 at the beginning of April to under 34 by the end of last week, including a drop of two points on Friday. While this is an encouraging sign, the VIX is still well above its long-term average of 20.
CMRG analyst Daniel Coker says there are two possible explanations for this seeming conundrum – either the rally is anticipating the end of the market decline, or this is a correction from an overly sold-off situation.
Commentary from Credit Suisse Tremont attributed the improvement in risk appetite to the follow three factors:
1) Better tone to certain macro data on forward looking output indicators
2) the Fed’s expansionary policy — the quantitative easing (QE) has kept yields low and was especially positive for mortgages, allowing for the mini-boom in refinancing to continue
3) further intervention in the financial system, particularly the announcement of the PPIP program to purchase toxic assets from financial institutions, which helped boost market confidence, along with new IMF lending powers announced at the G20 meeting.
Credit default swaps have also retreated from recent highs, as this chart of the European and North American CDS benchmarks shows:
Analyst Gary Kelly at NY-based broker-dealer Tradition Asiel Securities believes that despite recent narrowing in the CDS market to near-term lows and the attendant improvement in sentiment, risk factors are still elevated:
We recognize that credit risk looks to finally be easing, this along with new lows on the VIX suggest concerns are beginning to abate. However, both still remain at elevated level implying that risk still remains a concern, despite near term improvements. We also think improvements in CDS markets are likely to lead an improvement in credit conditions and the availability of credit. This should mean that the positive impact of further CDS narrowing will take some time to feed through the financial system. While we are more positive on stocks, we think the near term rally is still too aggressive for the current improvement in credit markets and continue to expect a retracement in stocks.
Moreover, Kelly believes the positive signs in the credit markets look “more than discounted” in the continued equity rally, and that 800 on the S&P looks like a more reasonable level.
In short, FT Alphaville agrees with CRMG’s Coker, who maintains:
it’s not yet time to declare a final end to the freeze.
Related links:
Prospects for US high-yield debt grim, S&P says – FT Alphaville
Will CDS spreads tumble in February? – FT Alphaville