Friday, June 10, 2011

Credit spread update

Bearish sentiment is surging. Investors are nervous, and the prices of risky assets are down. The above charts show the impact of investors' concerns on credit spreads. While it's no fun to suffer losses on stocks and corporate bonds, what we've seen so far is in the nature of a correction, not a collapse. Credit spreads are higher and the prices of corporate bonds are lower, but it would take a lot of bad news to push spreads significantly higher. Higher spreads equate to a higher yield, and that provides investors with a cushion against further losses. Plus, as these charts show, spreads already are quite elevated relative to where they have been during times of relative calm. Translation: the market is priced for some pretty ugly news, so it makes sense to be bearish only if you are truly very concerned that the outlook is going to continue to unravel, and in a big way.

As this chart of 2-yr swap spreads suggests, the level of systemic risk is quite low in the U.S. and only moderately elevated in the Eurozone. This presents a big challenge to the bears, since U.S. swap spreads are too low to be consistent with further economic and financial market deterioration.

UPDATE: As the next chart shows, this stock market correction has been unusual since the magnitude of the selloff has not been matched by a similarly large rise in the Vix index. Combined with the low level of U.S. swap spreads this suggests that there is a lack of meaningful drivers for the selloff, and thus it may be overdone.


NormanB said...

Again, you are not showing spreads. You are showing two graphs and we are supposed to interpolate the 'spread'. I suggest you have a second panel on each graph that has one series minus the others for a true 'spread'.

Scott Grannis said...

The "spread" of a corporate bond is the difference between the yield on a corporate bond and the yield on a Treasury bond of comparable maturity. It is therefore a measure of how much additional yield investors require to compensate them for the perceived default risk of a corporate bond; the higher the spread, the greater the perceived risk. Showing the two yields would add nothing to the informational content of the spread.

Steve Fulton said...

Scott--what do you make of the difference in euro swap spreads and US swap spreads? Is that the European bank exposure to the PIGs?

Scott Grannis said...

Steve: I think so, what else could it be?

Bill said...


Why don't the traders who cause the big movements in the market pay attention to logical analysis like yours and sell off? Are they trying to get the small investor (like me) to freak out and sell so they can pick up stocks at cheap values?