Yield curve/duration

While the US Federal Reserve has already begun to chop rates down - a remarkable 125 bps in the space of eight days - the European Central Bank (ECB) has maintained its hawkish tone and has kept its hand off the easing button. The futures markets are, however, pricing in several moves by the ECB, 50 bps by September 2008 - another 25 bps by year-end, a pattern which, in terms of Europe’s historical relationship to the US monetary cycle, seems reasonable.

For the ECB inflation remains its biggest headache as it waits for any proof that the effects of soaring commodity prices will not be imported into wages, and then to core inflation in the euro-zone. However, evidence appears to be mounting that Europe’s economy is beginning to flag and that the momentum of growth is slowing.

Some ECB Council members think that GDP growth could be below trend and that the liquidity squeeze being exerted by banks will continue to pose greater risks to growth in the future. Although France’s economic numbers seem so far immune to these pressures, consumer confidence is waning in Germany, Spain and Italy. Europe’s growth is largely export-led so the economy is (perennially) more vulnerable to external shocks given the weakness of its own domestic demand.

Covered bonds

The jumbo market has seen a good amount of issuance this year, but the issue sizes have been smaller, probably reflecting market tensions and perceived instabilities. New issue premia have also been decidedly generous. It is, however, worth noting that although jumbo issuance and liquidity did suffer badly during the worst of the crisis, private placements of covered bonds remained active and successful.

But the jumbo market remains divided into a clear two-tier system, with Spanish cedulas, UK and Irish covered bonds trading at ever higher spreads, while the rest remain largely unaffected. Those three countries in particular are experiencing especially tough conditions in their property markets. Mortgage lending growth in Spain has dropped to its lowest level in a decade, while UK mortgage approvals fell by 37.8% in December 2007.

The announcement by Commerzbank that it was to merge two of its mortgage bank subsidiaries, Essen Hyp and Eurohypo came as no surprise at all. The two banks together rank first in terms of jumbo volume outstanding and second in terms of new issuance over 2007, having a combined market share of around 25%.

Investment grade credit

Credit spreads are still under pressure and have been revisiting new highs in the aftermath of the US Fed’s double rate cut. Although there had been a degree of stability as 2007 ended, a combination of weaker US economic data, some spectacularly bad results from the banks and news of multiple Fed cuts sent first the equity markets and then credit into a serious downspin and extreme volatility.

Just how far will spreads go? The is the problem of when, where, and in what, to put money: such is the nature of markets driven by fear, there is an extremely high probability that they will overshoot. It seems that equities might be moving nearer to ‘fair value’.

Markets have aggressively re-priced quite a sharp slowdown in European earnings growth, though neither European stock nor credit markets are yet pricing in a growth recession in Europe.

Concerns over the stability of the world’s financial system remain, and so although a large amount of bad news has already been priced in, there is surely the potential for markets to overshoot on the downside.

It would seem unlikely that credit spreads will be able to de-couple themselves from equity markets should there be another down-leg.

High yield

Although high yield (HY) indices reflecting credit spreads are reaching historic levels, the outlook remains rather bleak. As one analyst put it, HY has nowhere to hide: the supply pipeline fills and investors will not buy. Actually HY has performed slightly better than investment grade in the overall spread widening, whereas the opposite occurred in equities.

European HY is such a young market and it is not particularly helpful to look back for clues as to how to move forward. Analysts and researchers have to construct hypothetical HY indices to try to estimate what might have happened in similar situations in the past. This is not ideal, but can give some pointers as to general trends.

What does seem likely is that there will not be a significant decoupling between US and European HY, and that the high probability of a US recession will be a strong driver of spreads as companies with higher perceived credit risks on the whole underperformed. Much of the investment grade widening has been due, of course, to financials.

Emerging markets

It is a tricky time for emerging markets (EM) as the US, and now possibly European, growth falters and tensions remain in the money markets. While the general ability of EM economies to withstand external pressures has undoubtedly improved in recent years, with the negatives worsening, it would be unwise to believe that EMs will emerge unscathed. Those economies with inflation edging higher, those with already loose monetary policy, or with large current account deficits funded by portfolio flows, are likely to be find it hardest to attract investor attention.

The Polish authorities have not yet set the date for the country to enter the euro as they want first to fulfil the Maastricht criteria. Finance minister Rostowksi has suggested that currency appreciation was ‘damaging’ to Poland, and introducing the euro would be a good way of avoiding the effects of a strengthening currency. Although these comments rather unnerved investors, it does seem unlikely that the government would actually do anything to ‘cap’ the zloty.

While Poland frets about the possibility of 4% inflation, Venezuela’s year-on-year inflation has soared to over 24% and even that may be artificially low due to official price controls. The government is losing popularity both with business and its people, and, possibly, international investors.

Credit derivatives

The news flow continues to be bad. There have been more actions by the rating agencies as they have been downgrading a wide range of instruments. Both Fitch and S&P gave the marketplace a bigger jolt when they downgraded from AAA to AA the ratings of FGIC, one of the US monoline bond insurers. In fact both agencies also left the insurer on continued negative credit watch.

Moody’s has recently announced that it would be reviewing its activities in the way it rates mortgage-related securities in particular. It has suggested that it could devise a new rating scale for structured products that would be quite different to its corporate and government debt scale.

All the credit rating agencies have been under intense pressure during recent months; many investors are justifiably upset that some of their nominally top quality assets, with their credit wraps and supposed triple-A ratings, have been so badly damaged.