C.M.O. 12.24.2009
Credit Market Overview
December 24, 2009
The passing of the Winter Solstice left us blanketed in white. Winter + white, for many, = snow and many of those same “many” are headed off to the slopes this Holiday season. I’m not going to talk about slopes today, but I am going to talk about curves. Now, now, it is a family oriented time of year so before you get carried away let me tell you that the curves I have in mind are those related to yield and credit.
The first curve I want to talk about is the yield curve and funny enough, its slope. For the equity centric readers out there the slope of the U.S. Treasury yield curve, most often measured by the difference in yield between the 2yr. and 10yr. Notes is used as an indication of investor’s outlook on rates and as such, growth. A big difference between the yield on the 2yr. and the yield on the 10yr. says that the market expects rates to be higher in the future while a small differential between the two expresses the exact opposite view. Better prospects for future growth minus low and steady short term rates equals a steep yield curve.
To that end, the spread between 2’s and 10’s closed last night at 282bps which broke the previous high of 276bps set back on May 27th of this year. Prior to that, the last time the yield curve was this steep was in 1992 and 2003. In both instances the economy was also recovering from a recession, although nothing like the Great Recession we just experienced. Also to be noted is that in both cases the Federal Reserve did not touch the rate dial for over a year.
Tony Crescenzi, a PM at PIMCO said recently, “the previous peaks ‘didn’t occur until the expansion was gaining some steam, and we don’t know yet that’s the case’”. Which could be interpreted as meaning, yes the curve is steep but it could get steeper. Dan Greenhaus, who took Tony’s old job at Miller Tabak & Co., seemed to confirm this view when he said, “The Fed isn’t going anywhere for now”.
The other set of curves that can provide clues as to what the market thinks about the future are those in the credit world. These can also be examined on a spread basis e.g. the difference between one maturity and another and in some cases there is a lot of information to be gleaned from that number. Most often when default seems imminent and the shorter maturity CDS level is greater than the longer as investors believe if the crisis is averted ultimate survival has a higher probability of occurring.
CDS spreads are more often examined on an absolute basis as the higher they are the worse the financial outlook for the specific entity is and vice versa.
A chart of the 5yr. (benchmark) CDS for investment grade bonds in 2009 peaked at 262bps on 3/9 of this year and closed last night at a new low for 2009 of 83bps. Looking at a graph, the movement appears more like a mogul run than a freshly groomed bunny hill but the interim highs and lows pretty well match the opposite in the equity indexes.
The shape of the high yield index is the same with the high for 2009 hit on 3/6 at 1890bps and last night’s close coming in at 510bps.
An interesting note with regard to the two CDS indexes: The absolute high for the crisis in the high yield index occurred this past March at the level stated; the high in the investment grade index, however, was actually reached last November at the 280bp level.
Lower CDS levels are usually a sign of improving financial health; although as we now know nothing is guaranteed, ever. Additionally, a steep yield curve is a sign of future growth, with the same caveat of course.
Could these two, together, just maybe, possibly be signaling better times ahead? One answer might be: Could they be worse?
Enjoy the Holiday shortened week, the long weekend and if you are traveling, travel safe.
Jim Delaney
