Outlook 2010: As Confusing as the Dollar and Stocks Rallying Together

Sunday, January 3rd, 2010

With the carry trade ‘rollover’ in full swing, short dollar bets are being covered, while those in the yen are being extended, hence the 4% rise in the dollar index (DXY) during December, and the yen’s devaluation. How the carry trade “rollover” goes, will determine the bias of market. That is, if the expansion in yen carry funding is quicker than the covering of short dollar trades, the markets bias could extend higher, though modestly, and more than likely, the next 6 months will be accompanied by greater volatility.

Outlook 2010: As Confusing as the Dollar and Stocks Rallying Together, January 4, 2009, GlobeAdvisor.com.

During the last several weeks, I have discussed the U.S. dollar and yen carry trades, in Carry Trades Make and Break Markets, and Does the Dollar Rally Threaten the Loonie and Commodities? I believe the subject of carry trading will be centre stage as we get further into 2010.

The point of writing about all of this, is not so you can run out and start trading currencies, although you can, but rather to recognize that the market is now getting a coronary bypass as a result of the resumption of the yen-carry trade. Deflationary economic news out of Japan means we can all breathe a little easier, since the yen now costs less to carry than the dollar. The dollar funded carry trade was destroying the dollar, jeopardizing world trade, and severely undermining the dollar’s role as primary reserve currency. In essence, the dollar funded carry trade was unsustainable. Even the Japanese wanted this distinction back.

Matthew Brown, Bloomberg, writes, “For the first time since before credit markets began to seize up in 2007, investors are starting to favor selling the yen instead of the dollar to fund higher-yielding investments.”

Read my latest instalment in GlobeAdvisor.com:

Outlook 2010: As Confusing as the Dollar and Stocks Rallying Together, January 4, 2009, GlobeAdvisor.com.

Tags: Bets, Bias, Bloomberg, Centre Stage, Commodities, Coronary Bypass, Credit Markets, Devaluation, Distinction, Dollar Index, Dxy, Economic News, Full Swing, Instalment, January 4, Loonie, Matthew Brown, Reserve Currency, Resumption, Volatility, Yen Carry Trade, Yen Dollar
Posted in Markets | 2 Comments »

Richard Karn: Nobody’s Right When Everybody’s Wrong (Chapter 2)

Thursday, November 26th, 2009

On Tuesday of this week we featured chapter 1 of Richard Karn’s fascinating e-book, Credit and Credibility, about the future of  markets, the global economy, global credit markets, and the 5 most pressing issues in the midst at this ‘hinge of history’ we have arrived at.

Karn has been described as one of the finest analysts and writers in the financial industry. Karn happens to be the featured guest speaker in an upcoming webinar (1 CE credit), on December 2, on the subject of currency debasement, sponsored by BMG Inc.

Chapter Summary: Credit and Credibility

Chapter 1: Pay no attention to the man behind the curtain! discusses fiat currency, the financial excesses and abuse it engenders, interventionist policy response to perpetuate it, and the role of the US dollar going forward;

Chapter 2: Nobody’s right when everybody’s wrong develops our contention that all fiat currencies today have become derivatives of the US dollar;

Chapter 3: May you live in interesting times explores the extent to which emerging markets can decouple from “consumer” economies and the role of China as the litmus test for the thesis;

Chapter 4: The report of my death was an exaggeration details our contention the world has had its fill of “financial innovation”, and the only way the US economy will recover will be through its traditional strengths in agriculture, manufacturing, invention, and hard work; and

Chapter 5: Passing laws, just because offers our assessment of the anthropogenic global warming debate and pending legislation.

Below we are very pleased to feature once again, for its relevance, the full Second chapter. Karn offers us a hype-less, lucid, insightful, look at the “macro” picture and begins to answer leading questions, proffered from his profound research. Yesterday, we featured some of Richard Karn’s latest thoughts. Very interesting reading. Enjoy!

Credit and Credibility

Chapter 2: Nobody’s right when everybody’s wrong

Arguably more effective than the military adventurism that dominates the headlines, what amounts to American cultural imperialism has subtly seduced large swathes of the world, and it has not been limited simply to a taste for fast food, film, and fashion.  The far more addictive aspect has been the successful overseas marketing of the “debt culture” via the financial innovation associated with the securitization (derivative) markets, which at $27 trillion has constituted the US’ largest export of the 21^st century.[1] This is the realm of the money center banks.

Enticed by various forms of off-balance sheet ‘accounting’ skullduggery, very few large banks globally managed to resist the siren song of easy profits and big bonuses offered by these financial innovations simply because it appears the only restriction on ‘profits’ was how far a bank dared to push its exposure.  That these vehicles were purposefully unregulated only increased their allure: calls for regulation as far back as 1998,[2] and again in the aftermath of the Enron scandal when these vehicles’ deceptive capabilities were fully exposed, were shouted down at every turn by none other than Alan Greenspan, Larry Summers and Robert Rubin and their cohorts in the SEC,[3] ostensibly not to stifle innovation or to drive markets offshore. But the behavior at Enron, far from being viewed as a cautionary tale prompting stricter agency enforcement, was adopted as the exemplar by money center banks-the very same banks, incidentally, that had made the ongoing fraud at Enron possible through a host of derivatives and special investment vehicles[4] the likes of JPMorgan, Citibank et al[5] actively marketed to Enron; instead, derivatives were the mechanism use to transmit the cancer globally.

This tacit government sanction suggests to us then that in effect the whole financial crisis only came to light because of what amounts to a falling out amongst thieves. No investigative reporter or oversight committee or regulatory watchdog safeguarding the interests of the public discovered and exposed any wrong-doing: major international banks’ books just became so overloaded with god-awful paper they knew may well be worthless that they grew terrified of loaning money to each other even over night for fear of not being repaid.[6] Once inter-bank lending stopped, credit creation froze, and the Ponzi-scheme parallel in the fiat currency mechanism began to breakdown.

The securitization and derivatives markets were so thoroughly corrupted by ‘innovation’ that if a bank shuffled paper, adjusted notional values and tweaked their infallible computer models furiously enough, they could arrive at the happy position of not requiring any capital reserves whatsoever to make loans. In other words, major banks worldwide indulged in what amounts to rampant uncollateralized lending-literally creating and distributing unfathomable amounts of money in the form of debt issuance from nothing, secured by nothing.  And quite possibly worth nothing.  It is widely assumed the still undisclosed expenditure of $2 trillion of taxpayer money referred to in the previous chapter was used to purchase boatloads of this stuff in order to stave off the recognition by the public that this behavior had rendered many of these ‘too big to fail’ money center banks literally insolvent; similar bailouts have been undertaken by governments worldwide.

Concurrent with the runaway lending, central banks throughout the world were channeling trade surpluses with the US as well as with each other into US Treasury bonds while simultaneously creating equal amounts of domestic currency to weaken it in order to maintain export competitiveness. This got so out of hand that today two-thirds of the world’s assets are denominated in US dollars.[7] The most controversial of these arrangements has been the de facto vendor financing agreement China has extended to the US: China suppressed the yuan, exports exploded, and it accumulated surpluses; the US let the dollar fall, consumption exploded, and it accumulated debts.[8] Both actions were irresponsible and highly inflationary.  Combined with similar behavior from much of the world, it produced a flood of liquidity that was if not misinterpreted as emerging market prosperity, certainly overstated it.  At the time it was noted primarily for contributing to the low interest rate environment enjoyed in the US that enabled the American consumption binge accompanying the housing bubble.  Few realized housing bubbles were pandemic.[9]

Our analysis concludes it was never a case of a “global savings glut” as proclaimed by Mr. Bernanke and the Fed in 2005[10] and reiterated by ex-Treasury Secretary Paulson[11]earlier this year  to deflect blame for the global financial crisis but a global fiat currency glut-a case of rampant global monetary inflation. Too much money could be leveraged too many times and transferred between too many international markets too quickly.  In addition to masking the extent of fiat currency creation, it produced, by historic standards, rapid-fire sequential bubbles in a range of real assets and commodities supported by credible explanations like ‘the emerging market infrastructure build-out,’ or ‘they’re not making any more real estate’ or ‘emerging middle classes will want to improve their diets’ or ‘Peak Oil,’ and was reinforced by price action.  These bubbles, as they must be, were largely based on the sound reasoning, analysis and extrapolations of economic data, as was the price action that supported it on charts; however, positive technical chart patterns cannot readily distinguish between breakouts driven by a glut of fiat currency looking for a speculative return and the supply and demand imbalances in this instance attributed to emerging market growth. Momentum produced the self-reinforcing hype of being right-something the ETR fell victim to itself-and as markets have discovered, it works in both directions. 

Download a PDF of the complete chapter here.

[2] O’Brien, Timothy L.: “A Federal Turf War Over Derivative Control”; The New York Times: 08.05.1998. http://query.nytimes.com/gst/fullpage.html?res=9B0DEFD81231F93BA35756C0A96E958260&n=Top%2FReference%2FTimes%20Topics%2FOrganizations%2FT%2FTreasury%20Department%20&scp=1&sq=Brooksley%20Born%20warns%20about%20derivatives&st=cse

[3] Whalen, Christopher:  “Statement to the Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities, Insurance, and Investment”: June 22, 2009, http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=1f354557-7b1f-4ffd-9014-e80435bc55b8

[4] McLean, B., Elkind, P. & Gibney, A.: Enron: The Smartest Guys in the Room; Magnolia Pictures: 2005.

[5] Thornton, Emily & France, Mike: “For Enron’s Bankers, a ‘Get out of Jail Free’ card”; BusinessWeek: 11.08.2008. http://www.businessweek.com/magazine/content/03_32/b3845036.htm

[6] Carney, Brian M.: “Bernanke is Fighting the Last War”; Wall Street Journal: 18.10.2008. http://online.wsj.com/article/SB122428279231046053.html

[7] Tett, Gillian: “In uncertain times, all that glitters is the gold standard”; The Financial Times: 09.04.2009.

http://www.ft.com/cms/s/0/d29f2728-249e-11de-9a01-00144feabdc0.html

[8] Grant, James: “For a better fuse box”; Grant’s Interest Rate Observer: Vol. 27, No. 6, 20.03.2009. http://www.grantspub.com

[9] Tomlinson, Richard & Doyle, Dara: “Ireland Loses Iceland Stigma as Euro Ensures No Return to Past”; Bloomberg: 04.06.2009.  http://www.bloomberg.com/apps/news?pid=20601109&sid=aBWMuYMHhfXw

[10] Cassidy, John: “Anatomy Of A Meltdown”; the New Yorker: 01.12.2008. http://www.newyorker.com/reporting/2008/12/01/081201fa_fact_cassidy?currentPage=all

[11] Yanping, Li: “China Central Bank Attacks Paulson’s ‘Gangster Logic’”; Bloomberg: 16.01.2009. http://www.bloomberg.com/apps/news?pid=20601087&sid=an1lSsWKeDs0&refer=home

Tags: Anthropogenic Global Warming, BMG Inc., Chapter Summary, China, Commodities, Credit Markets, Debasement, E Book, Emerging Markets, Exaggeration, Excesses, Fiat Currencies, Fiat Currency, Financial Innovation, Global Credit, Global Economy, Gold, Litmus Test, Man Behind The Curtain, May You Live In Interesting Times, oil, Policy Response, Richard Karn, Thesis Chapter, Traditional Strengths
Posted in Emerging Markets, Gold, Markets | No Comments »

Richard Karn: Credit and Credibility - Chapter 1

Tuesday, November 24th, 2009

5 months ago we featured a fascinating e-book by Emerging Trend Report’s, Richard Karn, Credit and Credibility, about the future of  markets, the global economy, global credit markets, and the 5 most pressing issues in the midst of this ‘hinge of history’ we find ourselves in.

Karn has been described as one of the finest analysts and writers in the financial industry. Karn happens to be the featured guest speaker in an upcoming webinar (1 CE credit), on December 2, on the subject of currency debasement, sponsored by BMG Inc.

Chapter Summary: Credit and Credibility

Chapter 1: Pay no attention to the man behind the curtain! discusses fiat currency, the financial excesses and abuse it engenders, interventionist policy response to perpetuate it, and the role of the US dollar going forward;

Chapter 2: Nobody’s right when everybody’s wrong develops our contention that all fiat currencies today have become derivatives of the US dollar;

Chapter 3: May you live in interesting times explores the extent to which emerging markets can decouple from “consumer” economies and the role of China as the litmus test for the thesis;

Chapter 4: The report of my death was an exaggeration details our contention the world has had its fill of “financial innovation”, and the only way the US economy will recover will be through its traditional strengths in agriculture, manufacturing, invention, and hard work; and

Chapter 5: Passing laws, just because offers our assessment of the anthropogenic global warming debate and pending legislation.

Below we are very pleased to feature once again, for its relevance, the first full chapter. Karn offers us a hype-less, lucid, insightful, look at the “macro” picture and begins to answer leading questions, proffered from his profound research. Tomorrow we will feature some of Richard Karn’s latest thoughts, and on Thursday, we will share Chapter 2 with you. Very interesting reading. Enjoy!

Credit and Credibility

Chapter 1: Pay No Attention to the Man Behind the Curtain

Americans’ willful ignorance of all things economic combined with a blind faith in our elected officials has made us all complicit to one extent or another, even if by omission, in the financial crisis rocking our country.  Most of us have been viscerally aware of the economic problems our country faces, but as with health check-ups after a certain age we’ve become loathe to visit the doctor for fear of what all those warnings we’ve been studiously ignoring really mean.  And the truth is that you do not need a doctorate to know that our economy is displaying the pathology of a critically ill patient that has been so badly, and we would argue purposefully, misdiagnosed that the disease itself has escaped real treatment while those treatments administered to the symptoms have only served to accelerate the progress of the disease.

We all want to believe that our government is acting in our best interests, that its shortcomings and failures are a matter of well-intentioned incompetence and not something more sinister.  But political pandering to special interest groups routinely takes precedence over the common good and is largely responsible for bringing us to the brink of economic collapse today.  In what has become an all too familiar scenario, successful lobbying resulted in the de- or self-regulation of another segment of the financial industry, which was accompanied by the concurrent elimination, subversion, or de-fanging of agency enforcement, and has culminated in another financial crisis rife with corruption, the cost of which is once again being borne by American taxpayers.  It strikes most of us as perfectly obvious that politicians cannot serve two masters, especially when one pays better and arguably preys on the other, but the practice continues unabated-as is witnessed by the financials sector’s continuing influence in Washington despite the revelations of the last 18 months.

The sheer scale of the debacle guarantees it will be the subject of myriad forensic dissections regarding what went wrong in the US and why, but the ETR submits historians will eventually point to the root of the problem being the very nature of the US dollar itself.  The dollar has been a purely fiat currency since August of 1971 when President Richard Nixon ended its convertibility to gold.  We support the contention that it is the inherent lack of fiscal restraint attendant to the subjective administration of a fiat currency regime rather than a rules-based currency accessible to all, such as a gold standard, that has by design or default culminated in the problems extant in the US economy today; that the dollar is the world’s reserve currency has startling implications for the global economy well beyond the heated rhetoric its mismanagement has provoked amongst our allies, trading partners and rivals alike.

Let us not equivocate here: the economic failure we are witnessing today is not with capitalism as many would have us believe but with the abuse engendered by the interventionist policies that have been put into practice since the US dollar became a purely fiat currency. It is not a coincidence that since ending the dollar’s convertibility to gold America has been transformed from the largest creditor nation on earth to the largest debtor nation, nor that it has fallen from one of the most admired nations on earth to one of the most reviled.  Any economic system whose foundation rests on the shifting sands of a fiat currency is destined to collapse: this has been the case with every single fiat currency in history, twenty failing during the 20^th century alone,[1] and the reasons are not difficult to fathom.  When a government holds its currency-literally its stock in trade-in low regard, which history tells us a fiat currency regime invariably does when it can conjure money at will to spend as frivolously as it dares, inevitably certain of  its citizens will too, giving rise to a Culture of Cheating. No longer restrained by such quaint notions as sound money of tangible lasting value or living within our means, the unbridled expansion of credit has witnessed a corresponding increase in the frequency of financial crisis, each of escalating magnitude and attended by ever more pervasive corruption.

Interventionist policy responses implemented ostensibly to resolve one crisis serve as well to foster the development of the next because the ’solution’ never addresses the root of the problem, only its latest chaotic manifestation.  Despite demonstrating time and again that low interest rates combined with massive liquidity injections invariably lead to asset bubbles that also invariably collapse,[2] that accurately summarizes the Fed and Treasury’s uniform response to crisis: promote the assumption of more debt as the means to restore economic growth.  But artificially stimulating growth through the creation of debt has been proven over the years to diminish the effect of each effort due to the increasingly debilitating economic drain attendant to servicing the accumulated debt, the misallocation of easy credit toward consumption rather than production, and the specious growth attendant to siphoning off ‘profits’ from transactions that merely shuffle the new paper hither and yon.  The growing imbalance between the service and manufacturing industries is reflected in the persistent deterioration in results: in 1966, each dollar borrowed produced ninety-three cents of GDP growth; by 2007, a borrowed dollar produced less than twenty cents of GDP growth.[3] (Please refer to the charts on page 5.)  In other words, each new effort requires more ’stimulus’ than its predecessor in order to produce a similar result: we term this policy rut, which we believe has spilled over into many aspects of American society, the doctrine of ‘more of the same, only harder’ because the desired outcome is not to cure the problem but to perpetuate it by deflecting it in a new direction.

Nearly four decades of experience with the fiat dollar is plainly telling us that this doctrine has failed, and until the fiat dollar is rejected, the progression of financial crises will continue to accelerate until our economy, and indeed quite probably large swathes of the global economy, is hopelessly gutted and lay in ruins.  We see this reflected in our vulnerable household finances which have deteriorated to the point we increasingly rely on revolving credit instead of savings as the most important source of liquidity after our jobs.[4] We see it in the uncontrolled growth of US trade imbalances, military adventurism, deficit spending, un- or underfunded entitlement programs, and ever more debt issuance and monetary expansion that have culminated in American taxpayers ultimately being responsible for more than $70 trillion dollars of debt,[5] not including that which we are currently assuming ostensibly to stave off financial collapse- a debt so large in fact it is literally only possible under a fiat currency regime.

Download Chapter 1 as a PDF.

Tags: 5 Months, Anthropogenic Global Warming, Blind Faith, BMG Inc., Certain Age, Chapter Summary, Check Ups, China, Complicit, Credit Markets, Debasement, E Book, Economic Problems, Emerging Markets, Excesses, Fiat Currencies, Fiat Currency, Financial Innovation, Global Credit, Global Economy, Gold, Guest Speaker, Health Check, Ill Patient, Incompetence, Litmus Test, Man Behind The Curtain, May You Live In Interesting Times, Policy Response, Richard Karn, Thesis Chapter, Traditional Strengths, Trend Report, Ups, Willful Ignorance
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Lending Conditions Improve, But Loan Demand Weak - Senior Loan Officer Survey

Tuesday, November 10th, 2009

This post is a guest contribution by Asha Bangalore* of The Northern Trust Company.

The main aspect that stands out in the October 2009 Senior Loan Officer Opinion Survey is that lending conditions were less tight than survey results of July 2009 indicated and there was a substantial improvement from the October 2008 survey when credit markets had frozen. The net fraction of banks that reported tightening standards on commercial and industrial (C&I) loans for large firms dropped to 14% during October from 31.5% in July and was noticeably below the peak of 83.6% reported in January 2009 (see chart 1). A similar reduction in the number of banks reporting tightening lending standards was reported for C&I loans to small firms (see chart 1).

However, demand for C&I loans continued to be weak according to the survey results of October but less weak compared with the July survey (see chart 2). It was noted that a decline in the need to finance inventories, purchases of plant and equipment, accounts receivables, and M&A activity were the reasons for soft demand for loans. The enormous excess capacity in place and soft consumer demand conditions are factors holding down the demand for C&I loans.

About 40% of banks reported increasing spreads of loan rates over their cost of funds, which is significant decline from the situation reported in October 2008 and January 2009 surveys (see chart 3). In sum, cost of funds is easing and underwriting standards of loans have been eased but demand for loans has to gather steam in the business sector.

Given the problems of the commercial real estate sector, the fact that there were fewer banks reporting a tightening of underwriting standards in October (33.9%) compared with the earlier quarters (see chart 4), suggests that the commercial real estate market may be in marginally less trouble than anticipated.

In the household sector, mortgage underwriting standards for prime loans were tightened by (slightly) more banks compared with the situation in July. However, bankers were less stringent with non-traditional mortgage loans (see chart 5).

There was a small improvement in the demand for prime mortgage loans reported in October survey compared with July, which is consistent with the increase in home sales.

The number of banks tightening standards for credit cards and other consumer loans fell in October, particularly in comparison with the situation in the second-half of 2008 (see chart 7). Are consumers willing to borrow? Chart 8 indicates that fewer bankers see a willingness among consumers to borrow in October vs. the situation in July. The Senior Loan Officer Survey indicates that bankers are more willing to lend (see chart 9) to consumers compared with the situation a year ago. Employment has to post a significant increase for households to be enthusiastic about borrowing.

* Asha Bangalore is vice president and economist at The Northern Trust Company, Chicago. Prior to joining the bank in 1994, she was consultant to savings and loan institutions and commercial banks at Financial & Economic Strategies Corporation, Chicago.

Source: Northern Trust - Daily Global Commentary, November 8, 2008.

Tags: Accounts Receivables, Bangalore, Business Sector, C Amp, Commercial Real Estate, Credit Markets, Decline, Excess Capacity, Household Mortgage, Household Sector, Inventories, Loan Demand, Loan Officer, Loan Rates, Mortgage Underwriting, Northern Trust Company, Opinion Survey, Quarters, Real Estate Sector, Substantial Improvement, Survey Results
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Canada’s IMF Upgrade an Important Sign Post

Friday, October 2nd, 2009

Canada’s GDP growth outlook got an upgrade from the IMF this week thanks in part to the outlook for commodities prices, as well as global demand coming from the developing world, in particular, China and India. Yesterday, we discussed the outlook for China and India in Mobius, Rogers, and IMF Love China.

Bloomberg reports: Canada’s economy will grow more in 2010 than previously forecast and shrink more in 2009, helped by commodity prices that have rebounded ahead of a global recovery, the International Monetary Fund said in its World Economic Outlook report.

The U.S.’s biggest trading partner will contract 2.5 percent in 2009 and grow 2.1 percent in 2010, the IMF said today. The IMF had predicted in July the Canadian economy would shrink 2.3 percent this year before rebounding to 1.6 percent in 2010.

“The recent rebound in commodity prices and reduced reliance on manufactured products have helped exports,” the report said. Canada exports oil, natural gas, metals and other commodities.

The IMF upgrade is an important signpost, and on its own, its great news, but it is actually far more important than it appears at first. As local investors, we tend to focus more on how we feel locally. You have to also pay close attention to Canada’s attractiveness to foreign investors.

Last week, we discussed the idea that China and BRIC peers may not be interested yet in investing in Canada Bonds, even though they are an ultra-safe alternative to US Treasuries, because the by-product would be a higher Canadian dollar, which means they would pay higher prices for our commodities exports.

Its true, for those reasons, they may not be interested in our paper, but on the other hand, large global investors are.

Our yields are not only higher (for now), our bonds are also perceived to be inherently safer than those of the US and UK, thanks to Canada’s sound fiscal position, stable credit market, and strong, and well capitalized banking system.

Andrew Willis reports that Ontario floated $2-billion of 10-year bonds, with a 4% coupon in the US, following an offering of Canada bonds made by the Federal Government.

Ontario tapped American credit markets on Tuesday with a $2-billion (U.S.) 10-year bond offering, a financing that follows of a federal government issue in the global market.

As part of a busy week, Ontario sold debt with a 4 per cent interest rate, offering investors a 73 basis points premium over the benchmark U.S. government bond. Bank of America/Merrill Lynch, BNP Paribas, Deutsche Bank and TD Securities were the lead underwriters.

These developments continue to provide evidence that Canada is in the uniquely advantageous position in the developed world to become a powerful, and key, world financial market, as a result of its once-in-several-decades position.

The benefits are two-fold.

1. Canada’s capital market as a magnet for foreign capital, attracting large investments from global investors looking for a safe haven in both the fixed income and equity markets. Canada’s risk/reward is favourably tilted for reward given its position in the global commodity complex and economic stability.
2. Canadian companies will be among the world’s biggest producers and vendors of commodities to the emerging markets, which all face long term shortages of oil, food, water, and metals.

Its high time for Canadians to recognize that Canada is poised for superior growth during the next decade.

The perfect-storm-like convergence of the credit crisis, which has investors looking for the safest places in the world to invest, and the dramatic redistribution of wealth and economic transformation that is driving the growth of the developing world, and the resultant demand for commodities has Canada is in the cross-hairs of both.

Bottom Line: Canadian investors should view any weakness in markets as a graduated opportunity to accumulate positions in Canadian banks and key, preferably under-levered, commodities producers.

Tags: 10 Year Bonds, Andrew Willis, BRIC, Canada, Canada Bonds, Canada Exports, Canadian Economy, China, Commodities, Commodities Prices, Commodity Prices, Credit Markets, Emerging Markets, Fiscal Position, Foreign Investors, GDP Growth, Global Demand, Global Investors, Global Recovery, Growth Outlook, India, International Monetary Fund, Investing In Canada, Ntario, oil, Outlook Report, Post Canada, Signpost, Uk Thanks, World Economic Outlook
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Robert Prechter: Inflation not a problem, deflationary depression in our future”

Saturday, August 15th, 2009

In the last week we’ve covered Robert Prechter, partly because we are fans, and partly because the material is available so that we can share it with you, in case you haven’t seen it yourself. For a long time, and as an advisor, I wistfully dismissed Elliott Wave Theory as technical market charting gobbledygook, as I was zealously taken with Buffett, and buy and hold, Value and Focused investing. High conviction about a way of doing things, especially in the investment business, is a necessity. However, I’ve since softened up because in hindsight, I missed out on a lot of opportunities that being open minded would have made possible. That’s my first point: Keep an open mind. Just because you believe some outcome (like a depression) is not possible (based on your knowledge), does not mean it will not come true.

I have covered Hugh Hendry’s thoughts throughout the course of this year, i.e. his way of seeing things, and his outlook, and I bought into his perspective on the equity and credit markets, and in a word, I got schooled, convinced that a deflation scenario is altogether possible, given the circumstances that the US and thus the world finds itself in at this time. It was made very clear. In hindsight, it made me realize how little I knew about the bond and credit markets. Now I know a lot more, but in reality its really just a little bit more. Hendry’s flagship Eclectica Fund was up 40% at the end of last year. My second point: Always be learning and don’t overestimate your knowledge.

Three years ago, one advisor that I was visiting with when I was a wholesaler for a fund company, showed me the basics of what Prechter was forecasting for long-term bond yields, the deflationary context, and the equity market. Prechter’s ideas represented a 20% directional bet in his book of business, because, “what if he’s right?” This translated into  having an up-to 20% weighting in long dated US treasuries and Canadian government bonds. That bet has paid off for the last 20 years, and the last two, has it not? So has cash and cash equivalents. My third point: Be prepared for what you feel is the least likely outcome.

I told that advisor, “You’re killing me, depressing me with this Elliott Wave Stuff, and I have to see other advisors today,” and the meeting ended. Don’t get me wrong though, the meeting was a good learning opportunity for me, and I haven’t forgotten it since. That advisor was, in my estimation, probably one of a few advisors in Canada who was thinking this way.

In any event, at each step along the way, I have had my eyes opened, and my mind, and my focus as an investor has shifted firmly to the camp that asks themselves, “What can go wrong, how can I lose money, what can go wrong with my thinking?”

Having said that, make sure you see this interview with Robert Prechter on the subject of the real threat of deflationary times. We will also recap the many thoughts of Hugh Hendry again in a future post. You won’t have to wait long, and in case you want to revisit those stories in the meantime, use the search box at the top of the page to search or click here for “Hugh Hendry” or “Deflation,” or “Deleveraging“, ” Bill Gross“. In the meantime, cash and long bonds have become attractive again.

Recently the dollar is said to have bottomed, and that thanks to the risk trade sucking money out of money market treasuries. In the interview, Prechter says that he believes the dollar will rise in value again for the next on to two years,” as the flight-to-safety trade, deleveraging continues, and earnings disappoint. Prechter doesn’t like the opportunities in the municipal or corporate bond market (too much risk for the average investor) and feels that investors should seek the safest, highest quality bets they can, so they can ride this out as safely as possible. He believes the dollar (treasury-bills) would be safe, and anything where the default risk is very, very low (government bonds) would be among the better bets.

Click play to view:

Source: Yahoo! Tech Ticker, August 11, 2009

Tags: Bet Book, Bond Yields, Buffett, Canada, Canadian Bonds, Canadian Government Bonds, Cash And Cash Equivalents, Circumstances, Conviction, Credit Markets, Deflationary Depression, Eclectica, Elliott Wave Theory, Estimation, Flagship, Gobbledygook, Governmen, Hindsight, Hugh Hendry, inflation, Investment Business, Little Bit, Long Time, Perspective, Robert Prechter, Seeing Things, Term Bond, Treasuries, Wholesaler
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Keep a Close Eye on Lending Standards

Tuesday, August 4th, 2009

The Federal Reserve Board’s Senior Loan Officer Opinion Survey is due to be published on August 17. This is an important document for assessing to what extent credit markets are thawing and confidence is returning to the financial system.

In the meantime, the European Central Bank’s Euro Area Bank Lending Survey has just been published. The net percentage of banks reporting a tightening of credit standards for loans to firms more than halved to 21% in the second quarter of 2009 from 43% in the first quarter - down from a peak of more than 60% in the third and fourth quarters of 2008.

As one would expect, there is a strong correlation between the lending standards in the US and Europe, as shown in the graph below. Based on the historical relationship it seems likely that the number of US loan officers reporting a tightening of lending standards later this month could decline significantly - from 40% to possibly in the region of 20%.

Source: Federal Reserve Board’s Senior Loan Office Opinion Survey and the European Central Bank’s Euro Area Bank Lending Survey

A decline in the lending standards of US banks should be bullish for the economic recovery and financial markets, but the demand for loans also needs to improve in order for confidence in the world’s financial system to return to more “normal” levels and liquidity to start flowing freely again, fueling a descent economic recovery. The Senior Loan Officer Opinion Survey due out in two weeks’ time should provide quite a few answers.

Tags: Bank Lending Survey, Banks, Confidence, Correlation, Credit Markets, Economic Recovery, Extent, Federal Reserve, Federal Reserve Board, Few Answers, Financial Markets, First Quarter, Graph, liquidity, Loan Office, Loan Officer, Loan Officers, Opinion Survey, Quarters, Second Quarter
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Credit Crisis Watch: Update – Improvement in Financial Stress Index

Friday, May 29th, 2009

I have often reported on the progress that has been made on the credit front and concluded as follows in my “Credit Crisis Review” of a few days ago: “Most indications are that the credit market tide has turned on the back of the massive reflation efforts orchestrated by central banks worldwide and that the credit system has started thawing.

“However, although the convalescence process seems to be well on track, it still has a way to go before confidence in the world’s financial system returns to more ‘normal’ levels, liquidity starts to flow freely again, and the economic recovery can commence.”

Further confirmation that the various central bank liquidity facilities and capital injections are having the desired effect of unclogging credit markets comes from Goldman Sachs’s Financial Stress Index (FSI). This index includes four factors related to the degree of impairment of financial markets: counterparty risk (US dollar 3-month LIBOR-OIS), liquidity risk (MBS to treasury repo differentials), refunding risk (commercial paper outstanding) and broader risk aversion (percentage of monies held in money-market mutual funds in relation to equity market capitalization).

As shown in the graph below, the FSI is now at the lowest level on a cyclically adjusted basis since the beginning of the credit crisis in August 2007.

“… the distress premium across assets has almost completely eroded. While the recent improvement [in the FSI] is largely due to the increase in risk appetite, indicated by money-market mutual fund outflows, there has also been improvement in other metrics as well,” said the Goldman team.

Source: Goldman Sachs - Strategy Matters, May 15, 2009.

Tags: 3 Month Libor, Adjusted Basis, Capital Injections, Central Banks, Convalescence, Credit Crisis, Credit Markets, Differentials, Economic Recovery, Financial Stress, Goldman Sachs, Liquidity Risk, Market Capitalization, Money Market Mutual Fund, Money Market Mutual Funds, Risk Appetite, Risk Aversion, Strategy Matters, Stress Index, Team Source
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Credit Crisis Watch: Thawing – noteworthy progress

Monday, May 18th, 2009

Are the various central bank liquidity facilities and capital injections having the desired effect of unclogging credit markets and restoring confidence in the world’s financial system? This is precisely what the “Credit Crisis Watch” is all about - a review of a number of measures in order to ascertain to what extent the thawing of credit markets is taking place.

First up is the LIBOR rate. This is the interest rate banks charge each other for one-month, three-month, six-month and one-year loans. LIBOR is an acronym for “London InterBank Offered Rate” and is the rate charged by London banks. This rate is then published and used as the benchmark for bank rates around the world.

Interbank lending rates - the three-month dollar, euro and sterling LIBOR rates - declined to record lows last week, indicating the easing of strain in the financial system. After having peaked at 4.82% on October 10, the three-month dollar LIBOR rate declined to 0.83% on Friday. LIBOR is therefore trading at 58 basis points above the upper band of the Fed’s target range - a substantial improvement, but still high compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.

Source: StockCharts.com

Importantly, US three-month Treasury Bills have edged up after momentarily trading in negative territory in December as nervous investors “warehoused” their money while receiving no return. The fact that some safe-haven money has started coming out of the Treasury market is a good sign.

Source: The Wall Street Journal

The TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the peak of the TED spread at 4.65% on October 10, the measure has eased to an 11-month low of 0.67% - still above the 38-point spread it averaged in the 12 months prior to the start of the crisis, but nevertheless a strong move in the right direction.

Source: Fullermoney

The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread increases, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans, so they charge a higher interest rate to offset that risk. The opposite applies to a narrowing LIBOR-OIS spread.

Similar to the TED spread, the narrowing in the LIBOR-OIS spread since October is also a move in the right direction.

Source: Fullermoney

The Fed’s Senior Loan Officer Opinion Survey of early May serves as an important barometer of confidence levels in credit markets. Asha Bangalore (Northern Trust) said: “The number of loan officers reporting a tightening of underwriting standards for commercial and industrial loans in the April survey was significantly smaller for large firms (39.6% versus peak of 83.6% in the fourth quarter) and small firms (42.3% versus peak of 74.5% in the fourth quarter) compared with the February survey and the peak readings of the fourth quarter of 2008.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, May 4, 2009.

“In the household sector, the demand for prime mortgage loans posted a jump, while that of non-traditional mortgages was less weak in the latest survey compared with the February survey. At the same time, mortgage underwriting standards were tighter for both prime and non-traditional mortgages in the April survey compared with the February survey,” said Bangalore. In other words, more needs to be done by the lending institutions to revive mortgage lending.

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, May 4, 2009.

The spreads between 10-year Fannie Mae and other Government-sponsored Enterprise (GSE) bonds and 10-year US Treasury Notes have compressed significantly since the highs in November. In the case of Fannie Mae, the spread plunged from 175 to 26 basis points at the beginning of May, but have since kicked up to 38 basis points on the back of the rise in Treasury yields.

Source: Fullermoney

After hitting a peak of 6.51% in July last year, the average rate for a US 30-year mortgage declined markedly. However, the rise in the yields of longer-dated government bonds over the past eight weeks - 57 basis points in the case of US 10-year Treasury Notes - resulted in mortgage rates creeping higher since the April lows. Also, the lower interest rates are not being passed on to consumers, as seen from the 414 basis-point spread of the 30-year mortgage rate compared with the three-month dollar LIBOR rate. According to Bloomberg, this spread averaged 97 basis points during the 12 months preceding the crisis.

Fed Chairman Ben Bernanke said on May 5 that “mortgage credit is still relatively tight”, as reported by Bloomberg. This raises the possibility that the Fed will boost its purchases of Treasuries to keep the cost of consumer borrowing from rising further. [The Fed has so far bought $95.7 billion of Treasury securities from $300 billion earmarked for this purpose. Similarly, purchases of agency debt of $71.5 (out of $200 billion) and mortgage-backed securities of $365.8 billion (out of $1.25 trillion) have taken place.]

Source: Fullermoney

As far as commercial paper is concerned, the A2/P2 spread measures the difference between A2/P2 (low-quality) and AA (high-quality) 30-day non-financial commercial paper. The spread has plunged to 46 basis points from almost 5% at the end of December.

Source: Federal Reserve Release - Commercial Paper

Similarly, junk bond yields have also declined, as shown by the Merrill Lynch US High Yield Index. The Index dropped by 40.8% to 1,291 from its record high of 2,182 on December 15. This means the spread between high-yield debt and comparable US Treasuries was 1,291 basis points by the close of business on Friday. With the US 10-year Treasury Note yield at 3.13%, high-yield borrowers have to pay 16.04% per year to borrow money for a 10-year period. At these rates it remains practically impossible for companies with a less-than-perfect credit status to conduct business profitably.

Source: Merrill Lynch Global Index System

Another indicator worth monitoring is the Barron’s Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. There has been a solid improvement in the ratio since its all-time low in December, showing that bond investors are growing more confident and have started opting for more speculative bonds over high-grade bonds.

Source: I-Net Bridge

According to Markit, the cost of buying credit insurance for American, European, Japanese and other Asian companies has improved strongly since the peaks in November. This is illustrated by a significant narrowing of the spreads for the five-year credit derivative indices. By way of example, the graphs of the North American investment-grade and high-yield CDX Indices are shown below (the red line indicates the spread).

CDX (North America, investment-grade) Index

Source: Markit

CDX (North America, high-yield B) Index

Source: Markit

In summary, the past few months have seen impressive progress on the credit front, with a number of spreads having declined substantially since their “panic peaks”. The TED spread (down to 0.67% from 4.65% on October 10), LIBOR-OIS spread (down to 0.63%% from 3.64% on October 10) and GSE mortgage spreads have all narrowed considerably since the record highs.

In addition, corporate bonds have seen a strong improvement, although high-yield spreads remain at elevated levels. Credit derivative indices for companies in all the major geographical regions have also shown a marked tightening since the November highs.

Most indications are that the credit market tide has turned the corner on the back of the massive reflation efforts orchestrated by central banks worldwide and that the credit system has started thawing. However, although the convalescence process seems to be well on track, it still has a way to go before confidence in the world’s financial system is restored and liquidity starts to move freely again.

Tags: Basis Points, Capital Injections, Commercial Banks, Credit Crisis, Credit Markets, Credit Risk, Desired Effect, Libor Rate, Libor Rates, London Banks, London Interbank Offered Rate, Negative Territory, Noteworthy Progress, Sign Source, Substantial Improvement, T Bills, Target Range, Treasury Bills, Treasury Market, Wall Street Journal
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Senior Loan Officer Opinion Survey – credit conditions are improving

Tuesday, May 5th, 2009

The Federal Reserve Board’s Senior Loan Officer Opinion Survey has just been published. This is an important document for assessing to what extent credit markets are thawing and confidence is returning to the financial system. The analysis below is a guest contribution by Asha Bangalore*, vice president and economist at The Northern Trust Company.

The number of loan officers reporting a tightening of underwriting standards for commercial and industrial loans in the April survey was significantly smaller for large firms (39.6% vs. peak of 83.6% in the fourth quarter) and small firms (42.3% vs. peak of 74.5% in the fourth quarter) compared with the February survey and the peak readings of the fourth quarter of 2008 (see chart 1).

At the same time, the cost of borrowing for both small and large firms declined in the April survey from the peak in the fourth quarter of 2008.

Although the terms of loans eased in the recent months, the demand for loans remained weak (see chart 3), reflecting the massive liquidation of inventories that is underway. In particular, the demand for loans was essentially unchanged at a weak level for large firms but was weaker with respect to demand from small firms (see chart 3).

The commercial real estate sector is mired with problems. The demand for loans is noticeably weak and loan underwriting standards for commercial real estate have eased only slightly (see chart 4).

In the household sector, the demand for prime mortgage loans posted a jump (see chart 5), while that of non-traditional mortgages was less weak in the latest survey compared with the February survey.

At the same time, mortgage underwriting standards were tighter for both prime and non-traditional mortgages in the April survey compared with the February survey. In other words, more needs to done here to revive home sales.

Loan officers had reduced the stringent conditions for non-credit card consumer loans but were nearly unchanged vis-à-vis credit cards in the latest survey compared with the previous survey.

The demand for consumer loans also improved to the extent it was less negative (see chart and at the same time fewer loan officers were less willing to extend loans to consumers (see chart 9).

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, May 4, 2009.

*Asha Bangalore is vice president and economist at The Northern Trust Company, Chicago. Prior to joining the bank in 1994, she was consultant to savings and loan institutions and commercial banks at Financial & Economic Strategies Corporation, Chicago.

Tags: Commercial Real Estate, Consumer Loans, Cost Of Borrowing, Credit Markets, Federal Reserve Board, Fourth Quarter, Household Sector, Industrial Loans, Inventories, Loan Officer, Loan Officers, Mortgage Loans, Mortgage Underwriting, Northern Trust Company, Opinion Survey, Prime Mortgage, Real Estate Sector, Stringent Conditions, Time Mortgage, Traditional Mortgages
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Tony Boeckh: Life After the G20 Meeting

Tuesday, April 14th, 2009

Tony Boeckh postulates on how the global economy is changing in the midst of the credit crisis, and following the outcome of last week’s G20 meeting in London.

Here is an excerpt from this informative and enlightening paper:

“The underlying cause of the credit meltdown and near-collapse of the global banking system was the deeply flawed international monetary system. This enabled the US to run large and persistent current account deficits since the mid-1980s (Chart 1). This in turn allowed credit at US financial institutions to expand at a pace which was not only unsustainable, but put many millions of families and firms in totally untenable debt servicing situations (Chart 2 - next page). They spent substantially beyond their means over many, many years, which is the counterpart of the collapse in US savings.”

This dynamic has left the US, as a country, massively over-indebted to foreigners who have acquired a huge net claim on the US, which represents the foreign financing of US overspendng.

So, we are left with US residents over-indebted to their financial institutions and the US, as a country, over-indebted to foreigners. While the former - US borrowers and lenders - are being bailed out on a grand scale, the debt to foreigners is another matter entirely. In particular, as Chart 1 also shows, the cumulative US current account deficit since the mid-1980’s, now totals $7.5 trillion and is climbing at the rate of $700 billion per year, down from $800 billion recently.

Without going into complications, there are a variety of capital flows into and out of…

Read this whole paper by Tony Boeckh, Boeckh Investments, HERE.

Boeckh is right at home in the global credit markets. From 1968 to 2002, he was chairman, chief executive and editor-in-chief of Montreal-based BCA Publications, publisher of, among others, the highly regarded Bank Credit Analyst, a monthly big-picture analysis of the U.S. economy and financial markets. BCA is now owned by Euromoney.

He was also chairman of Greydanus, Boeckh and Associates from 1985-99, a fixed-income investment firm which managed $2-billion in assets when it was sold to Toronto-Dominion Bank in December, 1999.

With a PhD in finance and economics from The Wharton School, University of Pennsylvania, Mr. Boeckh has taught economics at McGill University and is a founding trustee of the Fraser Institute. [Financial Post]

Tags: Account Deficits, Bank Credit Analyst, Banking System, Boeckh, Canada, Capital Flows, Counterpart, Credit Crisis, Credit Markets, Current Account Deficit, Financial Institutions, Financial Markets, Fixed Income Investment, Foreigners, Fraser Institute, Global Banking, Global Credit, Global Economy, International Monetary System, Investment Firm, Mcgill University, Meltdown, Mid 1980s, Phd In Finance, Postulates, Right At Home, Toronto Dominion Bank, Wharton School University Of Pennsylvania
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Credit Crisis Watch: Some Positive Developments

Wednesday, February 4th, 2009

Are the various central bank liquidity facilities and capital injections having the desired effect of unclogging credit markets and restoring confidence in the world’s financial system? This is precisely what the “Credit Crisis Watch” is all about - a regular review of a number of measures in order to ascertain to what extent the thawing of credit markets is under way.

First up is the LIBOR rate. This is the interest rate banks charge each other for one-month, three-month, six-month and one-year loans. LIBOR is an acronym for “London InterBank Offered Rate” and is the rate charged by London banks. This rate is then published and used as the benchmark for bank rates around the world.

After having peaked on October 10 at 4.82%, the three-month dollar LIBOR rate declined sharply to 1.08% on January 14, but the healing process has since not made headway, with the current rate at 1.23%. LIBOR is therefore trading at 98 basis points above the upper band of the Fed’s target range - a great improvement, but still steep compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.

Source: StockCharts.com

Importantly, US three-month Treasury Bills have been heading higher, especially over the past few days, to 0.32% after momentarily trading in negative territory in December as nervous investors “warehoused” their money while receiving no return. The fact that some safe-haven money is now coming out of the Treasury market is a good sign.

US three-month Treasury Bill yield

Source: The Wall Street Journal

The TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the TED spread’s peak of 4.65% on October 10, the measure has eased to a seven-month low of 0.91% - well above the 38-point spread it averaged in the 12 months prior to the start of the crisis, but nevertheless a strong move in the right direction.

Source: Fullermoney

The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread increases, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans, so they charge a higher interest rate to offset that risk. The opposite applies to a narrowing LIBOR-OIS spread.

Similar to the TED spread, the narrowing in the LIBOR-OIS spread since October is also a move in the right direction.

Source: Fullermoney

Despite the interbank lending rates having declined from their peaks, banks have significantly curtailed the amount of money they are actually lending. The US Depository Institutions Aggregate Excess Reserves continue their ascent at levels far in excess of the amount banks need to keep on deposit to meet their reserve requirements (see chart below). Although this measure recently started turning down, the level indicates that the balance sheets of banks remain under pressure, especially in view of the fact that the value of some assets is not known. As mentioned before, a definite peak in the Excess Reserves graph should coincide with a turning point in the recovery of banks.

Source: Fullermoney

The spreads between ten-year Fannie Mae and other Government-sponsored Enterprise (GSE) bonds and ten-year US Treasury Notes have also compressed significantly during November and December, but have since kicked up again. However, to ensure the ultra-low rates on offer from the Fed are passed on to home buyers and those refinancing existing mortgages, mortgage spreads need to tighten further.

Source: Fullermoney

Higher Treasury rates resulted in the national average rate for a US 30-year fixed mortgage pushing up from 4.96% to 5.10% over the past two weeks (after hitting a peak of 6.46% in October last year). However, the lower rates are not being passed on to consumers, as seen from the 387 basis-point spread of the 30-year mortgage rate compared with the three-month dollar LIBOR rate. According to Bloomberg, this spread averaged 97 basis points during the 12 months preceding the crisis.

Source: Fullermoney

The Fed’s Senior Loan Officer Opinion Survey of January 2009 contained indications of better tidings. Asha Bangalore (Northern Trust) said: “There were fewer bank officers reporting they had tightened loan underwriting standards for commercial and industrial loans for both small and large firms in January compared with December (see two charts below). In the case of both large and small firms, the demand for loans was weaker in January compared with December. Although the history of these data is short, in 2001, the demand for loans turned around only after the recession had reached its last leg, whereas the peak for the number of banks reporting tightening standards peaked slightly ahead.”

As far as commercial paper is concerned, the A2/P2 spread measures the difference between A2/P2 (low-quality) and AA (high-quality) 30-day non-financial commercial paper. The spread has declined markedly to 1.79% from almost 5% at the end of December.

Source: Federal Reserve Release - Commercial Paper

Similarly, junk bond yields have also declined, as shown by the Merrill Lynch US High Yield Index. The Index dropped by 25.3% to 1,630 from its record high of 2,182 on December 15. This means the spread between high-yield debt and comparable US Treasuries was 1,630 basis points by the close of business on Tuesday. With the US 10-year Treasury Note yield at 2.89%, high-yield borrowers have to pay 19.19% per year to borrow money for a ten-year period. At these rates it is practically impossible for companies with a less-than-perfect credit status to conduct business profitably.

Source: Merrill Lynch Global Index System

The iBoxx Investment Grade Corporate Bond Fund (LQD) and High Yield Corporate Bond Fund (HYG) recovered strongly from their October/November lows until the beginning of 2009, but have since been correcting what appeared to be “too-much-too-soon rallies”.

The corporate bond sector is worth watching for opportunities arising at lower levels. Also, the high-yield instruments - under intense pressure because of an avalanche of defaults predicted by the ultra-wide spreads - could see spreads contracting markedly if the defaults are not as bad as those priced in.

Source: StockCharts.com

Source: StockCharts.com

Another indicator worth monitoring is the Barron’s Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. There has been an up-tick in the ratio since its all-time low in December, showing that bond investors are growing somewhat more confident and have started opting for more speculative bonds over high-grade bonds.

Source: I-Net Bridge

Goldman Sachs reports as follows: “Accounting for expected default losses, the premium in non-financial investment-grade bonds is several standard deviations above its 20-year mean. High-yield risk premiums are very high in absolute terms even taking into account a surge in default losses. But elevated sovereign spreads effectively put a floor on how much corporate spreads can rally this year.”

According to Markit, the cost of buying credit insurance for American and European investment-grade companies has declined strongly since the peaks of November. This is illustrated by the movement in the spreads (expressed in basis points) for the five-year credit derivative indices listed in the table below.

However, the debt of American and European high-yield companies, and all Asian and Japanese companies, has become dearer to insure. The increase of 196 basis points in the US CDX High Yield spread means an increased cost of $196 000 (up from $1,262,000 to $1,458,000) to insure $10 million of debt annually over five years.

• CDX (North America, investment-grade) Index: down from 218 to 196
• CDX (North America, high-yield) Index: up from 1,262 to 1,458

• Markit iTraxx Europe Index: down from 169 to 161
• Markit iTraxx Europe Crossover Index: up from 978 to 1,065

• Markit iTraxx Japan Index: up from 291 to 400
• Markit iTraxx Asia ex Japan IG Index: up from 307 to 363
• Markit iTraxx Asia ex Japan HY Index: up from 1,132 to 1,210

The graphs of the CDX indices are shown below, with the red line indicating the spread.

CDX (North America, investment-grade) Index

Source: Markit

CDX (North America, high-yield BB) Index

Source: Markit

Several firms have issued bonds at attractive yields over the past few days. “The success of these placings demonstrated that there is a market for new debt, but it has to come from high-quality issuers,” said Markit.

Lastly, the tables below show some country CDS statistics, again courtesy of Markit. These prices represent the cost per year to insure $10,000 of debt for five years. For example, Italy is in most trouble among the G7 countries with a cost of $167 per year to insure $10,000 of debt.

Among the G7 countries, it is noteworthy that Germany and Japan have a lower default risk that the US. It now costs $63 per year to insure $10,000 against US default for the next five years. Although this is down from $71 a week ago, the corresponding numbers were $8 early last year and $36 in November. As in the case of the US, UK CDS spreads are also trading close to record levels as investors are spooked by the levels of national debt.

The price of insurance against debt default by Eurozone members Ireland, Greece, Italy, Spain, and even Belgium, has jumped in recent weeks, yield spreads against German bunds have ballooned, and the sovereign debt ratings of Greece, Portugal and Spain have recently been downgraded. According to Asha Bangalore (Northern Trust), “These developments do not reflect an increased risk of default by any Eurozone member, but rather show that investors have finally woken up to the fact that not all Eurozone sovereigns are equal. The global credit crunch has led to an overdue market re-evaluation of the Eurozone members.”

A marked deterioration was also seen over the past few days in the sovereign credit risk of, amongst others, Russia, Kazakhstan and Lithuania.

In summary, the past few months saw progress on the credit front, with a number of spreads having peaked. The TED spread (down to 0.91% from 4.65% on October 10), LIBOR-OIS spread (down to 0.98%% from 3.64% on October 10) and GSE mortgage spreads have all narrowed markedly since the record highs. Corporate bonds have also seen a strong improvement, but high-yield spreads remain at distressed levels.

Although the investment-grade credit derivative indices have mostly shown a tightening since the highs of November, the high-yield indices are in some cases still close to their peaks.

Over the past few days, US Treasury Bills have started moving higher as investors switched some Treasury money to less risk-averse investments.

The credit market tide seems to be turning, although additional data are required to confirm that the banking system is on the mend. In short, progress has been made, but the thawing of the credit markets has a way to go before liquidity starts to move freely and confidence returns to the world’s financial system again.

Tags: Basis Points, Capital Injections, Commercial Banks, Credit Crisis, Credit Markets, Credit Risk, Desired Effect, Headway, Healing Process, Libor Rate, London Banks, London Interbank Offered Rate, Negative Territory, Safe Haven, T Bills, Target Range, Treasury Bill, Treasury Bills, Treasury Market, Wall Street Journal
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