Thursday, January 7, 2010

Credit spread update

Credit spreads continue to decline, and that is very good news. As both charts show, spreads have reversed all of the rise that occurred in 2008; in that sense, the Panic Recession of 2008 is now a distant memory. But as the second chart shows, spreads are still at levels that prevailed prior to and during the 2001 recession. So things have improved dramatically, but the market is still priced to some grim expectations.

The fact that credit spreads are still historically high tells me that the U.S. capital market is still a long way from being overly exuberant. In the past year the market has gone from anticipating a record-breaking depression and deflation, to now anticipating a run-of-the-mill recession. Nothing out there is priced to anything like a goldilocks scenario. Take the Treasury market, where 3-mo. T-bill yields are almost zero: that can only mean that people are still deeply distrustful of the future. Or consider eurodollar futures that reflect the expectation that the Fed funds rate will rise from 0.25% today to a mere 1.0% by the end of the year. If the market had any confidence in a V-shaped recovery, expectations for the Fed funds rate at year end would be much higher.

Bottom line: if you believe as I do that the economy can manage to grow 3-4% or perhaps a bit more this year—which would amount to a fairly anemic recovery given the severity of the recent recession—then equities, corporate bonds and emerging market bonds are still offering some very attractive valuations.


alstry said...


Based on the fact that cities, counties, and states are facing the biggest decline in tax receipts in history and facing massive deficits.......coupled with a rising expense outlook and sitting on record debt loads and servicing requirements.....

Do you think that the market is pricing in a massive government bailout of municipal obligations? If so, what do you think will be the inflationary impact?


Scott Grannis said...

State tax collections are a lagging indicator. If the economy continues to improve, I would expect to see states' fiscal conditions improve, perhaps significantly, over the next year. I don't believe a federal bailout is necessary, but I wouldn't rule it out. Bailouts are only inflationary if the Fed screws up.

brodero said...

Scott, with all the discussion about CRE,,,,could you explain
the change we have seen CMBS spreads and what they tell us...

Scott Grannis said...

CMBS spreads have tightened considerably in the past six months.

I think this reflects a) the general improvement in the economic fundamentals, b) the major improvement in all financial fundamentals, c) very accommodative monetary policy, d) rising inflation.

In short, easy money and a stronger economy are very likely to result in tighter spreads for just about every credit instrument, because they combine to reduce default risk.