Fri 28 Nov 2008
Credit Crisis Watch (November 28, 2008)
Posted by Prieur du Plessis under Investment, Markets, Money
For the world’s financial system to start functioning normally again, it is imperative that confidence in the credit markets be restored. In order to gauge the progress being made to unclog credit markets, I regularly monitor a range of financial sector spreads and other measures. By perusing these one can ascertain to what extent the various central bank liquidity facilities and capital injections are having the desired effect.
I am planning on updating this “Credit Crisis Watch” regularly as I believe a grip on the credit situation will be key to determining the appropriate investment strategy.
First up is the three-month dollar LIBOR rate. After having peaked on October 10 at 4.82%, the rate declined sharply to 2.13% on November 12, but the healing process has since experienced a setback with the rate edging up to 2.18%. LIBOR trades at 118 basis points above the Fed’s target rate of 1.0%, compared with 43 basis points at the start of the year.
Source: StockCharts.com
Importantly, the US three-month Treasury Bills are trading at a minuscule 0.071%, indicating that liquidity is still being hoarded.
US three-month Treasury Bill yield
Source: The Wall Street Journal
The TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.
Since the TED spread’s peak of 4.65% on October 10, the measure eased to 1.75%, but has since worsened to 2.10%.
Source: Fullermoney
The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.
When the LIBOR-OIS spread is increasing, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans so they are charging a higher interest rate to offset this risk. The opposite applies to a narrowing LIBOR-OIS spread.
The movement in the LIBOR-OIS spread over the past few weeks is similar to the TED spread and shows that credit markets are still not functioning smoothly.
Source: Fullermoney
As far as commercial paper is concerned, the A2P2 spread measures the difference between A2/P2 (low quality) and AA (high quality) 30-day non-financial commercial paper. Although the spread has declined from a record high of 4.83% to 4.27%, it remains at an elevated (i.e. crisis) level.
Source: Federal Reserve Release - Commercial Paper
Similarly, junk bond yields continue to scale new highs as shown by the Merrill Lynch US High Yield Index.
Source: Merrill Lynch Global Index System
Another indicator worth keeping an eye on is the Barron’s Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. A declining ratio indicates that investors are demanding a higher premium in yield for increased risk, showing waning confidence in the economy.
Source: I-Net Bridge
According to Markit, the cost of buying credit insurance for US and European companies eased somewhat over the past week as shown by the narrower spreads (basis points) for the following five-year credit indices:
• CDX (North American, investment grade) Index: down from 267 to 233
• CDX (North America, high yield) Index: down from 1,546 to 1,376
• Markit iTraxx Europe Index: down from 183 to 163
• Markit iTraxx Europe Crossover Index: down from 915 to 869
• Markit iTraxx Japan Index: down from 350 to 320
• Markit iTraxx Asia ex Japan IG Index: down from 452 to 360
• Markit iTraxx Asia ex Japan HY Index: down from 1,375 to 1,218
The graphs of the CDX Indices are shown below, with the red line indicating the spreads easing over the past few days.
CDX (North American, investment grade) Index
Source: Markit
CDX (North America, high yield) Index
Source: Markit
Lastly, some CDS statistics as at November 26, courtesy of Markit. These prices represent the cost per year to insure $10,000 of debt for five years. For example, Italy is in most trouble among the G7 countries with a cost of $139 per year to insure $10,000 of debt.
It is noteworthy that the US and UK CDSs are trading at record levels as unease over the level of national debt takes its toll on their sovereign credit risk.
The TED and LIBOR-OIS spreads have eased (i.e. narrowed) since the panic levels of October 10, whereas the CDX and iTraxx indices have also shown some improvement over the past few days. However, US Treasury Bills and high-yield spreads are still at distressed levels.
In summary, although some progress has been made as a result of central banks’ liquidity facilities and capital injections, the credit markets are not yet thawing.
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December 1st, 2008 at 1:46 am[...] good summary - Credit Crisis Watch (November 28, 2008) - - For the world’s financial system to start functioning normally again, it is imperative that confidence in the credit markets be restored. This post is the first issue of a “Credit Crisis Watch” that will gauge the progress being made to unclog credit markets. - Posted by Prieur du Plessis under - Investment Postcards from Capetown [...]
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November 28th, 2008 at 2:05 pm
Very useful set of graphs. Gives exc insight into what is happening outside of the stockmarket. Hope you can reprint these every fortnight. Will def help gauge when the mkt has bottomed and confidence/liquidity has returned.
November 28th, 2008 at 3:53 pm
your comments are clear and concise and most important - helpful. The only place I have seen all put together in package. You also include education for those of us not craftsmen in understanding international financial indexes.
I look forward to your follow on.
November 28th, 2008 at 4:06 pm
Very nice!!! Very concise.
November 28th, 2008 at 5:38 pm
Hi Prieur
I think the interest rate information is interesting. But I think it is misleading. In the great depression, the US was successful in managing price stability but we still had a depression. Today it looks like we are trying to manage interest rate stability. I don’t think that that is going to help us escape the depression.
That the credit markets, are still having problems, is a sign that the bankers still don’t trust one another. Washington has been trying to fix that problem. However, another one has snuck up behind them. The consumer and small businesses have stopped buying and borrowing.
In a way, General Motors is a microcosm of the US economy and illustrates the lack of sound fiscal policy. Here we are being asked to bail out the car companies. If noone is buying cars, why should we spend any time even considering this option?
Until the consumer and small business start buying and borrowing we are going nowhere.
I think you ought to add charts for the US National Restaurant Visits and Expectations and the Baltic Dry as proxies for consumer sentiment. I like that you have the Barrons’ Confidence Index but it is basically like a financial index.
November 29th, 2008 at 1:04 am
Hello PdP:
I am not sure how all the graphs help as there is nothing in there that says 15% rally over four days.
I would like your opinion of the following: why would 10 year Treasury yields be falling during the recent rally? Previously, you had mentioned that a rally would be accompanied by rising yields as a sign that the crisis has passed. This is the first stock rally in months where yields have fallen, and yields on the 10 year Treasury are at generatational lows. Falling yields generally imply a flight to safety and liquidity.
Your insights are welcomed!!
December 1st, 2008 at 2:47 am
Guy,
Evidently, while giant funds run by Montier, Grantham and others are buying the stock market, still others are viewing the rally as an opportunity to bail out. Remember that the Thanksgiving market was thin, meaning that it wouldn’t take a lot of buying to get it up. I think you answered your own question as to whether the crisis has passed.
December 1st, 2008 at 3:04 am
Prieur,
I wouldn’t mind seeing a monthly update of your “Credit Crisis Watch”.