Credit markets signaling rough waters ahead
Barney Frank and Goldman Sachs to the rescue.
The Dow Jones Industrial Average and the S&P500 averted near disaster today all because those two wacky sidekicks of the financial world pulled a rabbit out of the hat.
The story goes that Goldman Sachs, the firm we love to hate, made a late-day comeback after Barney Frank said he’d snuff a provision killing derivatives trading at the nation’s banks in the new financial regulation bill. The Goldman rally helped the Dow to erase most of the 200+ plunge today; the S&P500 actually eked out a gain. Damn! You would think Greece, Korea, or rising jobless claims would at least get one of the major stock indexes on this side of the pond to break through critical support levels. I mean, the FTSE at least was able to drop through 5,000.
For the sake of the economy, I’d like to say that I’m relieved the market rallied back above 10,000 on the Dow — but I’m not. I was equally unimpressed when the index crossed the dix mille bournes back in October.
That’s because I prefer to keep a closer eye on the credit markets — especially when it comes to reading the tea leaves of the economy.
The credit markets are less cartoon-like than equities. But they are wicked. For the past month or so they have been heading into a slow-mo laughing fit: You thought the recovery would be smooth? Ho-o-Ho-o-Ha-a-a-a-h! The stock market should shrivel at the humiliation.
Some call the bond market denizens vigilantes — because they force everyone to think about rising deficits, higher taxes, growth, and inflation. Stocks have more individual “stories” attached: A great leader or product; a market niche or dominance. They can be long-running tales with apogees and deep valleys – Apple or Worldcom. They inspire passions. Bond people are nerds. That’s how they get to be the leaders when its time for systemic upheaval. No one pays enough attention to their formulae and schemes. Interbank lending rates. Yawn. Credit default swaps. Where’s the remote, hon? But credit people can be prescient story tellers. And here’s the story that I hear today :
Banks are becoming more suspicious of one another and are slowly jacking up the interest rates on the loans they extend to one another. Bloomberg reports that the London Interbank Offered Rate now stands at 0.536 percent, up from 0.510 percent, the highest since last July. Another key rate, called the Libor-OIS spread, is showing signs of strain in the banking system, edging up to 31.1 basis points from 28.4 basis points. After the Lehman bankruptcy, banks became so worried about the solvency of the entire system that the Libor-OIS spread jumped to 364 basis points, or 3.64%. (The spread measures the cost of 3-month Libor vs overnight swaps rates.)
Investors are seeking safety. Treasury securities are rallying hard as investors seek cover from the debt woes in Europe; the Korean imbroglio is just a bit more oil to the fire — not the thing itself. The flight-to-safety didn’t happen overnight. It’s more than a month old (see chart below; click to enlarge). Indeed, Mike “Mish” Shedlock says that this is a “solvency crisis” – not a liquidity crisis. The flash-crash of May 6 was a liquidity crisis in extremis. A solvency crisis can only be solved through a long-term economic recovery.
NB: Gold is hitting record highs as some doubt the safe-haven status of Treasurys as the US faces mounting debt and slow growth.
The junk bond market has turned tail as investors reconsider the “all is almost well” story. The Wall Street Journal (in an item so short I thought I was reading USA Today) reported that new offerings have slowed to $2.2 billion, a quarter of the weekly pace for March and April. Further, in the past month, yields on junk bonds have jumped by more than one third, rising 1.62 percentage points to 7.02 percentage points versus benchmark Treasurys. The Journal glumly notes: “That is the biggest reversal since the market began to climb back from its lows of December 2008, said Martin Fridson, of Fridson Investment Advisors.”
Mish notes on his blog that seven junk bond offerings have been scrapped. Ouch.
Investment grade corporate debt is looking a little shopworn. Again, Bloomberg reports that wary dealers are widening the difference between the bid-ask spread on that sector. In other words, they’re buying at cheaper prices but not lowering their selling price all that much.
The crazy swings in stock prices over the past month have pointed to cracks in the recovery theory as well — a point Gluskin Sheff economist David Rosenberg has been making over and over for the past few weeks. The troubles overseas are prompting both stock and bond investors alike to reconsider the stream of “good news” that has emerged over the past year. They may just be noting that, once more, jobless claims are trending higher; the broadest measure of unemployment remains at record highs; and the housing market, the source of many of our woes, is still deeply wounded (see chart below). The truth is, the credit markets are telling us that the recovery is a long, long way off.
Yield curve graphic via Mish.
Housing inventories graphic via Calculated Risk.