Yield curve/duration

lthough neither the ECB nor the Bank of England (BoE) raised rates at the start of September, the US Federal Reserve (Fed) did step in to cut rates. While the US forward markets had over the summer already moved to discount an early autumn rate cut, the size of the half-point move did take the market rather by surprise. In the accompanying statement, the Fed suggested that there would probably be more cuts depending on the state of the financial markets. Equities soared on the news, as did the short end of the US Treasury market, steepening the curve. Globally government bond markets sold off on the news, reversing at least some of the flight-to-quality move. The markets, however, remain tense. Interbank borrowing rates normally stick closely to official rates, but LIBOR rates, for example, have been as much as 100 basis points higher. The lending banks are reluctant to lend to each other either because of worries about their own liabilities or the credit worthiness of their counterparties.

The continuing lack of confidence within the world’s banking system is what worries the authorities. If liquidity were to dry up, then the vicious cycle turns on the commercial banks squeezing them and the real economy.

Economists everywhere are already downgrading their GDP forecasts for 2008 by as much as 0.5% for Europe, blaming a combination of the US economic slowdown and the effects of a global ‘credit crunch’. With the aggressive Fed rate cut and the BoE’s £10bn (€14.3bn) injection into the money markets, the central banks are sending a clear message that they will stand by the financial markets.

Covered bonds

hough above reproach in terms of their credit worthiness and provenance, the Jumbo covered market were hit almost as badly as other investment grade assets. Not only have they underperformed government bond markets, bid/ask dealing spreads have also widened quite significantly as new issues caused almost instantaneous indigestion.

Some new issues, such as that from Banco Popular, have been cancelled or deferred to a later date, in the hope that the market will regain its composure. Norway’s first Jumbo covered bond issuer SpareBank 1 is still checking investor sentiment, and may also be postponed.

These have been disappointing times for the covered bond market generally and Jumbos in particular. That liquidity should dry up so comprehensively, despite the market’s special market-making agreements and electronic trading, is worrying.

The ill-fated attempt by the market makers essentially to create a two-tier market was badly received by issuers and the European Covered Bond Council which stressed the importance of a level playing field. Hopefully, valuable lessons will be learned and the market will regain both its composure and its enviable reputation of a properly regulated market with high liquidity and high quality.

Investment grade credit

here seems to be little doubt that credit and swap spreads will not get back to the extremely tight levels we saw before the subprime crisis erupted, not in this cycle at least. However, with the current uncertainty and volatility still uncomfortably high, and the likelihood that the flight to quality will continue, it is likely that there will be considerable to-ing and fro-ing.

Some credit will of course find it very hard to recover, most notably that of the banks themselves. Lehman Brothers paper, for example, finds itself in the uncomfortable position of its fixed income debt trading at a similar level to that of the government of Colombia: though ostensibly still rated A+ by S&P’s ratings agency, such is the extreme lack of confidence in the outlook for the bank that investors demand a much higher premium for their perception that investing in Lehman paper is a possibly very risky choice. Credit markets of all grades remain under pressure. There is a huge amount of refinancing of commercial paper due in the coming weeks in Europe and participants are steeling themselves for what could be very uncomfortable time, as supply has to be digested into a market which all but ceased to trade at one point.

High yield

he outlook for high yield is poor. With a deteriorating macro outlook and negative technicals, it is very hard to see how high yield doing anything but underperforming credit overall in the coming weeks and months. As liquidity falls, financings in any form will become more difficult for corporates and the default rates must surely rise, whether or not Europe heads into recession.

If confidence in the financial markets remains so fragile, companies might be forced to rely on lines of credit directly from the banks (are-intermediation), which could in fact make the credit crunch even more painful.

Capex is likely to slow significantly in coming weeks in response to the macro uncertainties and the difficulties in obtaining credit. An appreciating euro is already causing pain for Europe’s exporters. High yield spreads over government bonds are still below their longer term averages, which suggests that, in this deteriorating climate, there is still more widening to go.

Emerging markets

uring the week ending 17 August, emerging market (EM) equities suffered their largest losses since the 1997-98. EM bonds fared only marginally better.

For obvious reasons - risk re-pricing across all asset classes and geographic borders, investors needing to raise cash, and the general nervousness of US and global growth prospects - EM assets were always going to underperform government bonds in any global flight-to-quality move. Hardly surprising that those markets least penetrated by international investors, such as China and India, where foreign ownership is capped, have held up so well. The fact remains that majority of the EMs have never been in stronger macro-economic as well as socio-political conditions to withstand a marked slowdown in the US economy. Although volatility will cause damage at the financial asset level, many EM economies will be able to shrug these effect off. For those markets which had experienced rather more short term, or speculative capital, for example Russia, this tensions and turbulence may well cause more lasting damage.

Credit derivatives

he ABS CDO market was the first segment to suffer the effects of the meltdown in subprime, but it really did not take long for the non subprime-related CDO sectors to get caught up in the melee. Trading in CDOs remains limited, with both secondary and primary markets almost at a standstill. The atmosphere will remain fearful as the market contends with the constant headlines warning of yet more fund liquidations.

Third-quarter results for the banks are probably more eagerly awaited than ever before throughout all markets currently, and never more so by the derivatives markets. These figures should give a better insight in to who actually owns what and how much pain they’re in. Getting a better understanding of where the liabilities are stacked is an important stage in clearing the air and getting rid of the fear factor. However, it is very unlikely that normality will arrive shortly after the third-quarter results are over. It is much more likely that it will take rather longer.