Rally in credit
There is a growing consensus that the demise of Bear Stearns, the US investment bank, may have marked the low point of the current financial market problems. Although liquidity remains low and interbank lending is still far from normal, the belief seems to be that the worst of the banks' revelations are now in the public domain and that pervasive fear of the unknown is dissipating.
With the perception that perhaps the US Federal Reserve has justifiably come to the end of its policy of aggressive easing to stave off financial crisis, and that neither the financial system nor the real economy needs it, there is a growing feeling that one of the main themes for taking a bearish stance on the US dollar is also ending.
In Europe April's business surveys pointed to a weaker picture than previously thought and GDP growth forecasts are being revised downwards. Higher interest rates, higher commodity prices and a higher euro are together creating a strong headwind for the economy. With inflation still worryingly high, however, the European Central Bank (ECB) is likely to remain on hold for the near term at least, although news of weakness in the economy will have the forwards pricing in an earlier cut than the current before-year-end consensus.
Jumbo issuance continues to rise, albeit in a fairly restrained way. Several Spanish cedulas, following Sabadell's launch a few weeks previously, came to the market and were priced significantly apart despite both being two-year bonds. While part of this differential may be attributed to the fact that one of the issues was sold as a ‘jumbo', the 13 basis point differential between the highest and lowest suggests that investors, perhaps sceptical of the ratings, were looking at other factors too.
This differentiation in spreads has now been a feature of the covered bond (CB) market, and most especially for Spanish cedulas and UK covered bonds, for some time now and suggests that investors remain very sensitive to any perceived differences in issues, be they credit or structural.
The coming weeks will be rather trying for the CB market, as new CB supply will be coming at the same time as a hefty slew of new government bond issues across Europe. Coupled with a low redemption and coupon calendar, jumbo CB spreads could face pressure again as cash-poor buyers opt for the safety of the government market.
Investment grade credit
For the first time in many months, credit has been rallying pretty much across the board, with financials leading the way for the cash market. Synthetic spreads came in even more than cash, aided perhaps by short covering in CDS (shorts originated with the unwinding of CDOs, very possibly) and the fact that there was a significant amount of new supply of cash bonds.
That this rally included almost all every single name comes as a relief to everyone: with credit trading better on the back of some more optimistic data from the US, essentially a normal reaction to a change in economic risk, the ‘patient' is clearly feeling better.
However, with deteriorating macroeconomic conditions, the consensus suggests sideways trading may be the best to hope for in the coming weeks. Should there be more bad news from the euro-zone economy or some disappointingly weak data from the US, then it is hard to see how credit would actually rally.
Market liquidity in the money markets is still far from its best, reflecting the fact that not all other markets may be fully recovered and that ‘carefully' is probably still the best way to proceed.
High yield (HY) has been enjoying the rally, with huge relief that the worst of the liquidity crisis really does seem to be behind us. So far it has been a fairly broad rally, much like that seen investment grade bonds, with individual bond fundamentals ignored for the while.
Although there is hardly any agreement that we may have seen the spread wides in European HY, the suspicion that the outperformers may already have started their moves, does create quite an incentive to put the cash to work. There is still no new supply in this arena, so investors needing to put cash-inflows to work have to use the secondary markets, providing a healthy technical bid.
Previous bear market rallies have lasted several months and provided significant gains, and missing out could prove to be too painful for that notoriously short-termist fund buyer.
With the liquidity crisis easing, it seems a reasonable assumption that, eventually, fundamentals will once again take over as the main determinants of risk premia and avoiding the bad apples will once again become the name of the game.
Inflation has been rising across the emerging market (EM) universe, although given the respect with which most of the central banks are now held, panic selling in the face of widespread soaring food and commodity prices is a thing of the past. Though higher inflation has to be bad news for fixed income investors, Central banks with credible, and tested, anti-inflation mandates can ease or at least diminish much of the pain.
However, higher inflation data has probably been holding back EM debt markets which have not enjoyed as much of the rally as the other risk assets. And investors will be watching very carefully to see whether any central bankers look like wilting under these difficult conditions.
Russia's inflation problem is worse than many others' and Putin, now appointed prime minister, has a tough task ahead. He has stated that fighting surging inflation was the main priority for his government and that the aim is to get it down to single digits in coming years. Standard & Poor's has also upgraded Brazil to investment grade. Although the majority of investors predicted this, the move happened rather earlier than expected and it could provide a boost to Brazilian assets.
Across Europe the credit quality of synthetic CDOs has continued to deteriorate. For example, more details have emerged about changes Fitch will be introducing for rating structured credit. It seems likely when introduced, that a huge percentage, perhaps 45%, of AAA-rated tranches of synthetic corporate CDOs will be downgraded.
While in the long term the market needs to be re-assured that the agencies are tackling head-on claims that their methodologies have in the past been insufficiently robust, the headlines make for grim reading for this sector.
Although there are glimmers of light, with some interesting now products appearing, structured credit remains tangled up in a whole range difficulties. As long as the problems with LIBOR remain, then floating rate instruments will prove difficult to create and to price effectively.
With continued weak data coming from both the US and UK housing markets especially, securitisation products remain troubled and nowhere more so than in the structured markets, where they generally account for such a large part of the market.
There may be glimmers of hope: the more optimistic participants suggest that recent, slightly healthier subscriptions to some new securitisation deals signals some degree of recovery in the securitisation market as a whole.