PRINTMarket Update -- In the Markets
May 27, 2008
Monday, March 17, 2008, marked for many the turning point in the ongoing credit and liquidity crisis. A major financial institution had fallen, signaling to investors that the financial markets had finally hit rock bottom. The markets have since staged a formidable recovery. Credit spreads tightened dramatically as shorts were covered and fresh capital was deployed. The IG10 credit default swap index, which had flirted with 200 at its widest, tightened all the way back to 80. The CMBX series 4 AAA index, which tracks the cost of default protection on a basket of super-senior classes of commercial mortgage-backed securities, tightened from an intra-day wide of about 300 basis points to less than 100 basis points in just over a month. Treasury yields rose as the flight-to-quality premium quickly evaporated. Two-year notes rose 100 basis points in yield from their low of 1.35%, and the yield curve flattened 60 basis points between 2s and 10s.
The markets have clearly moved past the panic phase and have now completed the early stages of recovery. Initial momentum has stalled, and many of the various credit indices have retreated from their recent tights, spending the last few weeks seeking a new equilibrium. The corporate bond market has seen a healthy serving of new issues, and more supply is expected as issuers rush back into a newly reopened market to satisfy pent up demand for capital. Economic data has reminded us that the environment remains very challenging for businesses and consumers alike.
In the rates markets, the debate has heated up between the recession and inflation camps. Both have very compelling arguments and neither side seems to be giving up any ground.
The inflation story is impossible to ignore. While core CPI has moderated in recent months, it remains stubbornly high at 2.3% and headline inflation is running near 4%. The University of Michigan Consumer Confidence survey showed a sharp rise in inflation expectations in May, reflecting the steady march higher in food and gas prices. One-year inflation expectations spiked to a 25-year high of 5.2%, while long term (five-year) inflation expectations rose to 3.3%, their highest level in over ten years.
But the inflation data have done little to dampen the enthusiasm of the bond bulls in the recession camp. The rising food and gas prices that are pushing up long term inflation expectations are leaving consumers with precious little discretionary income. Household savings are dangerously low, the housing market is a wreck, access to consumer credit is tightening, and the job market is weakening. All of this makes it less likely that consumers will be able to increase or even sustain their spending habits. If demand for discretionary core goods and services declines, can prices still go up?
The net result of rising food and energy costs in a weakening economy is not core inflation but demand destruction and margin compression. Airlines are responding to the rapid rise in fuel costs by cutting routes and laying off workers. Automakers are reducing output. Retailers are scaling back expansion plans or closing stores. Manufacturers are trimming inventories and shedding jobs. These hardly sound like the type of conditions that fuel inflation.
It's hard to see what will turn this economy around. Federal stimulus checks will provide a one-time boost, but overall economic conditions seem to be worsening for consumers every day. Financial institutions also remain on weak footing, with further deterioration in loan quality and persistent strains on balance sheets. While some risk appetite has reemerged in the credit markets, there are willing sellers into the bid.
In consideration of all of the above, we have to concede that both the inflation and the recession arguments have merit, and the debate among the two camps will surely continue for some time. If pressed, we would probably lean more towards the recession argument, but while it may be tempting to buy Treasuries based upon an expectation of disappointing economic data, we would caution against getting long here. Regardless of which direction inflation is headed, valuations still appear rich.
Even after the recent backup, real yields remain near historic lows. Five-year notes are trading well below headline inflation and less than one percentage point above core CPI. The last time long term inflation expectations were as high as they are now, the five-year Treasury note was trading at yields close to 7%, more than double its yield today. Conversely, the last time the five-year was trading below 3%, the target fed funds rate was 1% and deflation was the market's primary concern.
Indeed, fundamental valuation methods make Treasuries look a bit expensive. Relative to their overseas counterparts, Treasuries also appear rich by historical standards. Add massive amounts of monetary and fiscal stimulus to the equation, not to mention increased Treasury issuance amid a growing budget deficit, and you have a pretty good argument to sell Treasuries. In spread sectors, we feel that some bargains can still be found in the highest tiers of the structured products markets and that name-specific opportunities still exist in corporates, but overall we feel that caution and a defensive posture are warranted. After all, when the debate is about inflation or recession, who really wins?
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