Tuesday, February 2, 2010

Credit spread update




The first chart shows spreads on generic 5-year Credit Default Swaps, and the second chart shows the difference between high yield (junk) and investment grade credits. CDS spreads are a nice, liquid proxy for generic credit risk with 5-year maturity. We've seen all three lines wiggle a bit to the upside in recent weeks, and that wiggle has coincided with an uptick in the VIX index, which is shown in the third chart, alongside the S&P 500 index. These wiggles are the market's way of climbing walls of worry. I doubt that they signal the end of the rally in corporate bonds or stocks.

As all three charts show, measures of risk and uncertainty have come down hugely, which is good, but they are still above the levels that tend to prevail during periods of tranquil markets and a healthy economy. No where can I spot any sign of irrational exuberance or a failure to appreciate that there is still plenty of risk and uncertainty out there in the world. Credit spreads are still fairly high relative to historical averages, and the VIX is still quite high as well. These are signs that the market is appropriately cautious, and worried that things might not continue to improve.

The threat of anti-business sentiment and higher-tax policies coming out of Washington seems like the likely catalyst for the market's latest bout of nerves. Bad policies can derail a recovery, so the market is reacting rationally to Obama's populist attacks on banks and big business. But meanwhile, the wheels of recovery continue to turn, and the economy has undergone some tremendous adjustments that open the door to continued improvement. You can't keep the U.S. economy down.

And as Obama is discovering, you can't impose a far-left agenda on the American people. The pushback has been huge. Free markets are not going to disappear anytime soon, and as long as this remains largely a free market economy, growth and rising prosperity are the default option.

3 comments:

Benjamin said...

Obama chose his words poorly in his "fight" with banks.

A legitimate question, however:

Should banks take FDIC-insured deposits, and than make highly-leveraged and risky bets with the deposits?

The ability and eagerness of modern "bankers" to make highly leveraged bets--we are talking 100-to-one sometimes--is breathtaking.

Essentially, they are "bet the bank" bets. Bet right, and management is richer than Croessus.

Bet wrong--and well, nobody goes to prison, new finance jobs can be had, and taxpayers will clean up the mess.

I think Obama is on the right track to limit risk-taking by institutions that choose to take FDIC insurance. Why Obama chose such terrible rhetoric to make this point is beyond me.

j said...

I find myself in the Volker camp when it comes to the banks. I would like to see the very large banks broken up. We need to bring back banks like Manny Hanny, Bankers Trust, NBD, First Chicago, Security Pacific, etc. When Continental Illinois failed it was just a speed bump for our financial system, it didn't take the US economy over a cliff. I think that we do need reasonable financial reform for the long term health of our economy, Glass Stegal served us well for over 50 years and helped provide the financial framework for the American Century, not all regulation is bad. I think free markets work best when there is a cop on the beat.

Family Man said...

January Senior Loan Officer Survey-
"For the first time in nearly three years, a small net fraction of banks reported an increased willingness to make consumer installment loans now as opposed to three months ago. However, demand for consumer loans of all types reportedly had weakened further since the previous survey."

Just for the starter.