Yield curve/duration

Central banks across the world have been putting in place new measures in order to melt the liquidity freeze.

Market conditions have generally improved over the month, although have hardly returned to anything like their historical norms. For example, spreads between LIBOR and other rates remain very wide suggesting that banks remain concerned about counterparty risk and are reluctant to lend to each other.

According to Goldman Sachs, the cumulative foreign inflow into US credit products between July 2007 and January 2008 was around US$101bn (€64bn), significantly lower figure than the US$301bn of inflows seen in the similar period of the last year. Over the same period, the US dollar’s trade weighted index has been weakening at an annualised 10%, its fastest rate of decline since 2002.

As Goldman Sachs points out, even if we assume that some of these inflows would have been hedged back into domestic currencies, the change in flows is so enormous that it surely is having a significant influence in the foreign exchange markets. They argue that, if the capital markets have indeed weathered the worst of the credit crisis then perhaps we may be reaching the point where the inflows into credit may be ready to return.

Covered bonds

Bund swap spreads have narrowed considerably from their highs, but jumbos have been left behind relative to swaps. The turning on of the issuance tap put pressure on the covered bond (CB) markets as investors chose to switch from existing holdings into new bonds rather than use their cash, causing spreads to government bonds to actually move out again.

Despite the spread widening, the arrival of new supply, albeit only in the shorter maturity area, has come as a relief to the market, bringing with it a sense that the worst is behind us and that a return to better health may be ahead. However, with wide bid-offer spreads and still small dealing sizes, the CB market remains mired in difficulty. Since the start of the year, jumbo new issuance has more than halved compared to 2007.

In the UK, the market was rather taken aback by news of a surprisingly large drop in house prices, the largest recorded fall since 1992. S&P’s, the rating agency, had already commented that it was expecting a big deterioration in both the UK and Spanish housing markets.

Investment grade credit

As the stampede to quality assets, ie government bonds, slows down, so stock markets have edged higher and credit spreads moved narrower. With some new issuance in the investment grade credit market in the US, the tone is somewhat calmer. Although more de-leveraging, and perhaps forced selling, will be required, there is a feeling that the process is becoming slightly less panicky and just a bit more orderly.

While equity markets have risen, they feel more like bear market rallies and conditions for true bull markets are some way off. Recent credit surveys suggest that the real money investor is already neutral or even slightly long credit and thus unlikely to be eager to add to exposure just yet.

CDS have hugely outperformed the cash market suggesting that there has also been a rush to cover shorts rather than any turning in investor sentiment. Liquidity remains poor in the secondary market and has shown little or no sign of improvement in recent weeks, and new issues have been coming at such attractive spreads making purchases in the secondary market even less appealing. It seems the squeeze on the shorts is driving the CDS market which is in turn dragging the more reluctant cash spread-market lower.

High yield

European high yield (HY) spreads have come off from their March highs but there remains the fear that those highs may be re-tested in the near future. In line with other markets, the focus for HY seems to be moving away from the dread of systemic risk in the banking sector and turning towards macro economic fundamentals and their implications for corporate balance sheets.

So moving back into centre stage is the default rate, widely expected to rise throughout this year. Such is the ongoing fragility in the HY market, and indeed all risky assets, that it would not be hard to predict that news of corporate defaults could cause considerable damage to the sector, perhaps more than might ‘normally’ be predicted.

During the first part of 2008, US IG indices fared worse than HY. Now, however, that outperformance is set to unwind, with the recession-bound US economy pushing up default rates, the US HY market will be coming under increasing pressure. Europe’s HY market will find it very hard to disassociate itself from the suffering US HY market.

Emerging markets

Overall, emerging markets (EM) debt spreads have traded in line with other risk assets, with no significant under or over performing markets or sectors. Several EM central banks have been raising rates in the face of increasing inflationary pressures both from within, from their own overheating economies, and imported from rising commodity prices.

Peru has been upgraded to investment grade by rating agency Fitch, reflecting the country’s strong fiscal and external accounts performance. It seems likely that the other big rating agencies, S&P and Moody’s, will also make such a move in the near future, although Moody’s currently rates Peru’s foreign currency debt two notches below IG and so make take longer than the others.

For Brazil, the wait may be more drawn out. S&P ought to be first as it already has Brazil just one notch below IG coupled with a positive outlook. However, a global slowdown is almost never helpful to any entity’s credit outlook and it is hard to see how Brazil could buck a slowing global trend.

In Pakistan, although the election results produced an outcome better than many had predicted, the coalition government of Prime Minister Yousuf Raza Gilani now has an economy facing considerable difficulties. Inflation is running well above target, both fiscal and current accounts are already in deficit and look set to worsen even more and the currency is coming under increasing pressure.

Credit derivatives

Although the feeling of near panic about the state of structured synthetic credit markets has abated a little, the sense of unease is still pretty acute. CDO liquidations have been speeding up over the past month. In terms of volume, 44% of the 2006/07 vintage structured finance (SF) CDO issuance is in technical default. The credit rating agencies have been actively downgrading synthetic corporate CDOs. New issuance volumes in CDOs remain extremely small.

Despite the market rally helping to lift prices further from levels that would trigger automatic unwinding of synthetic CDOs, the risk that there will at some point be great numbers of such unwinds is weighing extremely heavily upon the market. Whilst there is no real way of pinpointing when these could happen, for the next six to 12 months there is little likelihood of this danger just evaporating.