Yield curve/duration

At the very heart of the financial system, money markets remain almost paralysed and it is here that the recovery must start. Neither the global financial market nor the real economy can function without them. Without access to short-term funding, the banks are forced to sell assets as fast as they can, causing tumbling prices and plummeting confidence.

Stock markets have continued to plunge, sometimes recovering weakly, graphically demonstrating the morbidly accurate ‘dead cat bounce’. Volatility measures have gone sky high, and show no sign of diminishing. For most investors this has been a time of anxious waiting, spectators to the show. Unfortunately in this show the spectators can get hurt.

This global crisis has to be met with a global response and the very fact that the world’s central banks are so clearly co-ordinating their actions, is part of the reassurance the markets need at this time. The head of the IMF, Dominique Strauss-Kahn, has urged yet more co-operation and co-ordination, warning of a global meltdown unless further radical steps are taken. Government after government has announced packages to aid their domestic banks.

The euro-zone plan seems to be a similar version to that announced previously by the UK government. Issuance of new bank debt will be guaranteed until the end of 2009, governments agree to buy banks’ preference shares - perhaps the crucial element - and there is a commitment to recapitalise any large bank, that is, one deemed to be too large to fail.

Government yield curves have been very mobile, and the concerted central bank rate cuts sent curves into concerted bull-steepening mode, as short ends dropped dramatically and inflation worries evaporated. Historically, the negative impact of much higher government issuance has been outweighed by the deflationary pressures, which has kept yields low. Significant future easings are priced in across the world, and for now the very short end of yield curves is going to carry on driving the steepening.

Investment grade credit

It is estimated that some 60% of corporate lending in Europe is LIBOR related. It is thus absolutely essential that we see some sustainable recovery in the money markets in order for the credit markets to function at all. Perceived counterparty risks are too high, and banks are hoarding their cash rather than lending it to anyone.

In shoring up the banking systems across the world, governments are trying hard to prove that confidence can be restored and that it is now acceptable for banks to lend to one another. However, for the ‘real’ economy, access to credit is severely impaired too. With banks unwilling or perhaps unable to lend to each other, it is reasonable to assume that they will remain quite reluctant to lend to the non-financial sector too.

Even without knowing how or when stabilisation will occur, what has already occurred will very definitely be having a serious impact on global growth. Survey data, such as purchasing managers’ indices, are already pointing to a significant slowdown in economic activity. The effects of the ongoing credit crunch create  many uncertainties, but it does seem prudent to assume that the slowdown might be more, rather than less, severe than forecast and that corporate profits could remain under greater pressure for longer too.

High yield and emerging market

Are risks finally starting to come in to kilter with rewards offered? Or are record-breaking high yields and spreads still trying to warn of further trouble, and will new highs be reached? While not wanting to read too much into a couple of days’ trading, it is worth noting that in mid October, on the Monday after the previous week’s ghastly falls in stock and credit markets, and risk assets generally- spurred on by wildly ecstatic equities - high yield (HY), for one, had its first positive day in almost a month.

Despite the rally in the secondary market, there has been no issuance in HY, with issuers staying in the background until more sustainable stability is achieved. The ‘cushion’ of protection offered in HY is now substantial and very high default rates are already priced in. Both would-be borrowers and investors will be hoping that genuine stability might be just around the corner.

For emerging markets (EM) there are inevitable comparisons with the 1997 Asian crisis. However, although spreads have moved enormously this time around, they are nowhere near as wide as they got back then. This must in part be due to the fact that the current crisis originates not in Asia but in the US, but also because EM policy makers have continued to improve their countries’ economic finances, and financial infrastructures and indeed their own credibility, with respect to the rest of the world.

Looking forward, although most EMs are stronger today than a decade ago, there will undoubtedly be increasing disparities between the performances of the strong versus the weaker EMs, particularly as we enter a prolonged period of perhaps much lower economic growth and almost certainly lower investor risk.

Credit derivatives

The unwinding and settlement of Lehman’s defaulted credit derivatives - a notional amount of perhaps $400bn outstanding - created extreme worry and fear in the market, and was surely partly to ‘blame’ for triggering the collapse in stock markets in early October.

The grim reality of the imminent auction, and the knowledge that payouts were looming - combined with the fact that the other banks were unable to quantify their exposures to the CDS (credit default swaps) linked to Lehman - were certainly some of the biggest fear factors dominating the market that week.

Lehman had $110bn of senior bonds before it had to file for bankruptcy in September, and around four times as much in CDS linked to Lehman. Rumours had been spinning round the market about which banks would have to pay out most for being on the wrong side of the CDS trades when the Lehman bonds went into default, and the fear has ebbed and flowed.

The auction was held on 10 October at the end of one of the most dramatic weeks that the capital markets had ever experienced. At auction, Lehman bonds achieved only 8.625 cents on the dollar, meaning that the sellers of the Lehman CDS - the insurers of the debt - were looking at payouts of 91.375 cents per dollar owned.

It may in fact turn out that the absolute sums involved are not as great as feared and that many of the banks will be able to net off their exposure against other CDS. The US Depository Trust and Clearing Corporation (DTCC) runs the electronic central registry for the majority of CDSs. It stated that the size of the CDS market is probably overstated by the press, possibly by a factor of two, due to double counting exposure for both the buyer and the seller.

The DTCC also tried to clarify just how much money needed to change hands in the fallout from the Lehman bankruptcy, pointing out that cash payments due upon insolvency were combined with foreign exchange settlement obligations and calculated on a multilateral net basis. The DTCC estimates that the net funds transfer from net sellers of the protection to the net buyers are expected to be in the $6bn range, a much more manageable figure for the market to comprehend.

Topics