Risk Appetite Rebounds, But Can It Hold If The Fed Cuts 50bp?
Credit Market: How Is It Doing?
Conditions in the credit market showed a modest improvement this past week despite the ongoing tally of damage exacted by subprime losses at banks and insurers. Over the past few days, there were few headlines that should have evoked confidence from lenders. In fact, from the corporate world, the first quarter earnings season brought another round of major write downs from the largest banks. JP Morgan, Bank of America, Merrill Lynch and Citi all reported sharp declines in earnings and credit-related losses. Such an improvement under fundamental duress suggests lenders and investors may be growing accustomed to the steady write offs and that these losses are being viewed as past events. If this is the case, growing confidence may finally begin thawing the lending freeze and eventually stabilize the financial markets.
A Deeper Look Into The Changes This Week:
Considering the sizable write downs that have been announced this past week, the drop in risk premium underlying junk bonds and credit default swaps comes as the biggest surprise. The junk bond/treasury spread is only 40 bp from its multiyear highs; yet the cost of insuring corporate paper against default has fallen to a fresh three-month low. If the major financial institutions can avoid any Bear Stearns-like emergencies, it seems the market is growing more confident in credit quality.
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Demand for short-term paper is still very high; but both the T-Bill and Libor rates are working on modest rebounds. Last Thursday, evidence that credit conditions were improving was seen in the Fed’s $25 billion TSLF auction which received only $35.1 billion in bids compared to the $46.9 billion for the April 2nd swap. More pertinent to Fed watchers, the rate on the longer-term 2-year T-note crossed above the Fed Funds rate for the first time since June of 2006, suggesting the market’s outlook for rates has finally turned hawkish.
Financial Markets: How are they doing?
Volatility in the US equity market continued to fade this past week as the major benchmarks have settled into a steady advance. In fact, the Dow Jones Industrial Average has climbed back above 12,750 and the S&P 500 has surpassed 1,375. Interestingly enough, this bullish turn in equities has been helped along by an otherwise temperate earnings season. Heading into the first quarter corporate reports, analysts were revising their expectations for the S&P 500’s net earnings lower on a weekly basis. However, so far, many of the industry leaders (excluding those in the financial sector), while not reporting positive earnings growth, have beat the market’s overly pessimistic forecasts. The rebound in stocks also happens to accompany a general rebound in risk appetite with Treasuries seeing their biggest drop in face value in seven years last week and credit market gauges easing.
A Deeper Look Into The Changes This Week:
The axiom that a rising market floats all stocks was proven true this past week. While the benchmark Dow finally broke through the top of a three-month old range, a number of the sectors that are considered leaders for the broad stock market (and the economy for that matter) were failing to produce fresh highs of their own. Write downs have made the financial group a laggard. More importantly, the consumer sensitive components have also fallen behind. The retail, services and goods indices have slipped as the outlook for consumer spending falters
Traditionally, when the equity markets advance, volatility will decrease. This has been the situation with stocks this past week. The Dow’s break above resistance happened to coincide with a drop in the S&P 500 volatility index to its lowest level since November of last year. What’s more, this drop in the VIX has broken the steady rising trend that has sustained the volatility reading since the beginning of 2007. On the other hand, a put-call ratio reversal has kept its own trend intact. This sets the direction and volatility readings at odds with each other
U.S. Consumer: How are they doing?
There was little change to the steady decline in consumer sentiment this past week. Gasoline prices rose once again to record highs and the jump in crude to $120/barrel wouldn’t promise relief any time in the near future. What’s more, the Fed’s wrap up on the health of the economy last week confirmed economists and citizens’ dour forecasts. The policy group’s Beige Book reported growth had cooled since the last reading back in February. Casting a deeper shadow over the outlook, the housing market was referred to as anemic, consumer spending reportedly slowed, and the vital labor market weakened. Looking ahead to next week, the economic docket will no doubt have a major impact on consumer sentiment. Readings for first quarter growth and April NFPs are due next Wednesday and Friday respectively.
A Deeper Look Into The Changes This Week:
The more timely, consumer-related indicators have shown little improvement in recent weeks. Setting up next week’s non-farm payrolls report, total jobless claims rose to their highest level in four-years (even though first time filings eased). At the same time, American’s are struggling to sell and draw equity from their homes. Mortgage applications fell 14.2 percent last week to their lowest level in nearly four months. What’s more, with lending rates steadily rising over the past six weeks, conditions are clearly working against a housing recover.
Economic data centered on the health of the economy was relatively light last week, but one forward looking indicator has single-handedly countered the wave of bearish sentiment that has overtaken the US economy recently. The leading indicators composite (used to forecast growth over the coming three to six months) rose for the first time in six months. While this indicator hasn’t reversed speculation of a recession, it does support some policy makers’ forecasts for a short-lived contraction. Next week’s GDP number will decide the credibility of this outlook.
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