US Treasury yields positive as rate cuts on hold

Yield curve/duration

The oil price is on the rise, and indeed has been since the start of the year. There are a variety of factors all contributing to the higher prices: strong global demand, recent colder weather, production cuts from OPEC and tensions created by the capture of the fifteen British sailors in the Persian Gulf.

The US Federal Reserve let it be known that it no longer favours a tightening bias because of the deteriorating US growth indicators. However it did also state that inflation remains the ‘predominant policy concern’. This suggests that although the Fed may be done with rate hikes for now, it is too soon for the markets to be expecting rate cuts. This has led to a significant steepening of the US yield curve, which has become positively sloped as 10-year Treasury yields rose above two-year yields for the first time since last August.

The fate of the US economy remains key to the direction of global bond yields. Short-term interest rate futures in Europe do not appear to be pricing in a 4% Refi rate, despite the ongoing flow of strong economic news. Investors are pricing in a more aggressive slowdown for the US economy and the resulting downward pressure on US Treasury yields will keep European rates lower than Euro-zone economic fundamentals might argue.

 

 Covered bonds

The first covered bond issued by Bank of America (BoA) - in two €2bn tranches of five and 10 years - was extremely well received by the market. Such was the demand that the size of the deal was raised to €4bn from an initial figure of €2bn. The issue was well received, despite concerns that the troubles in the US sub-prime mortgage market might prove a negative for BoA. The issues came about two bps tighter than those of Washington Mutual, the only other US covered bond issuer, thanks to the stronger balance sheet of BoA.

There has been increasing speculation about a possible merger between two major issuers of Jumbo Pfandbriefe, Eurohypo and HypEssen after the latter’s CEO recently announced his resignation. Eurhypo’s CEO has stated that no merger is imminent and that there have been no talks about Commerzbank acquiring the remaining 49% stake in HypEssen. Eurohypo is a subsidiary of Commerzbank, which also owns a 51% stake in HypEssen. These two are the largest issuers of Jumbo Pfandbriefe, accounting for about a quarter of total market share. If there were indeed to be a merger, it seems that investors do not foresee pressure on Jumbo swap spreads.

 

 Investment grade credit

Trading has remained quite disjointed and edgy in the credit markets since the surge in volatility at the end of February. According to several manager surveys, many investors have been reducing credit exposure at least moving from overweight towards neutral. Support for the market has, however, remained strong and seems to be due more to the strong technical situation rather than to fundamentals.

News of economic weakness in the US is worrying and doubts remain as to whether the strength of the European and Japanese economies, and healthy earnings expectations, can sustain the current rosy global credit conditions. It seems likely, for now at least, that the market will scrutinise and react to every scrap of economic data looking for clues.

Moody’s, the ratings agency, has announced that it is to change again its bank rating methodology. The joint-default analysis (JDA), which Moody’s recently introduced, resulted in the upgrading of a range of banks because the methodology put more emphasis on the support financial institutions might expect to receive from governments. Investors questioned the validity of this approach and Moody’s have decided to downgrade this emphasis. Moody’s will review about 210 of the banks that were re-rated using the JDA method and expects to downgrade about 40-50 of them.

 

High yield

There are some potentially worrying comparisons to be made with the US housing market and the corporate high yield sector, not least the high liquidity and the minimal levels of protection for lenders and investors. US householders have been able to get loans without putting much or indeed any cash up front. Some mortgage providers now suggest that these borrowers have far too little to lose by declaring bankruptcy and defaulting on their loans.

The high yield market is already on alert due to the increasing number of leveraged buyout (LBO) transactions, and the concomitant damage to company balance sheets. What is interesting is the fact that European LBO transactions have seen a significant decline in the amount of equity in deals. So private equity - like the US householder who needs a minimal deposit on his mortgage - has less to lose if financial difficulties do emerge later on, which is not perhaps the healthiest trend for the high yield market.

 

 Emerging markets

Standard and Poor’s upgraded Poland’s long term foreign currency credit rating from BBB+ to A-. To some extent this move brings the S&P rating more in line with the ratings of the other two agencies, Fitch and Moody’s, but the move was still very welcome to the Polish markets. S&P, however, was very clear in its opinion that although the economic outlook is good and the growth prospects strong, the political situation is still a significant drag on Poland’s rating.

In Ukraine, there has been a marked increase in political tension with the apparent stand-off between President Yuschenko and Prime Minister Yanukovich. The markets have assumed that this turmoil will further delay the introduction of a freely floating Ukranian currency.

Emerging market debt spreads have essentially retraced all the widening that started at the end of February. However, volatility is once again on the rise and sentiment appears to be quite fragile. As in other asset classes, this tension is not derived from negative developments from within emerging markets themselves but rather from worries about the global economy and most especially the US.

 

 Credit derivatives

Will the current crisis in the US sub-prime mortgage market remain confined or might the contagion spread? The situation is bad, has generated considerable media attention, and has clearly worried the financial markets. The key question bothering the markets is whether the damage being witnessed now in that specific sector of the US mortgage market could spread to the broader market.

There have been rising borrower delinquencies and indeed some collapses of a few loan originators. Some have a suspicion that corporate synthetic collateralised debt obligations (CDOs) might be the guilty culprits because of the possibility that the underlying collateral within the reference portfolios may be exposed to the sub prime mortgage sector.

Initial analyses have indicated that the risk of the problem flowing through these corporate synthetic CDOs and into the general market is low, not least because the risky exposure is overall quite low, but also because the structuring of CDOs generally leaves a reasonable cushion against some downgrading of the reference credits. With the lack of real transparency, it is perhaps unwise to be discounting the dangers just yet.