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Credit Wrap
May 2 2008, Markit Credit Wrap - The Week in Perspective
The sharp drop in equity correlation in recent weeks is symptomatic of changing risk perceptions. Investors now see systemic risk as less likely given the Federal Reserve's actions over the past few months. The real economy is now becoming the focus of attention, and consequently idiosyncratic risk is driving the pricing of tranches. In this climate senior tranches will outperform those lower down the capital structure as there is less chance of widespread defaults damaging the subordination.
The shift in sentiment is reflected in the above chart. Financials are rallying even faster than they corrected. And the Fed is not finished yet. It announced today it was increasing the size of its Term Auction Facility, which offers one-month loans to banks, by 50% to $150 billion. In addition, it said that the Term Securities Lending Facility (TSLF) will now accept AAA-rated ABS. At the moment only AAA-rated RMBS and CMBS, as well as Treasuries and agency securities, are eligible for the TSLF. In a move coordinated with other central banks, the Fed also announced measures aimed at increasing the supply of offshore dollars in Europe. An examination of Ben Bernanke's writings on the Great Depression makes his activist approach unsurprising. Bernanke places great emphasis on the effect of banking crises on output, and is a proponent of the theory that instability in the financial sector caused the contraction in growth (some economists believe the reverse causality). In particular, he posits that the high "cost of credit intermediation", i.e. the cost of supplying credit, played a big factor in the economic slump. In light of this, his moves to improve conditions in the interbank market are consistent with his background as an economist.
In the UK, the Bank of England was uncharacteristically bullish in its semi-annual financial stability report. The Bank predicted that confidence and risk appetite would return gradually in the coming months as investors realised that the credit market correction had gone to far. Indeed, this has been reflected in the recent credit market rally. However, the CDS market remains prone to technical swings and short covering has undoubtedly played a major part in the spreads tightening. The Bank meets to decide rates next week, and the MPC is likely to be split over whether to follow the Fed and cut rates by 25bp or stay on hold. Arch dove Danny Blanchflower will surely press for a relaxation of monetary policy, while hawks Andrew Sentance and Tim Besley tend to stress the impact of lower rates on long-term inflation expectations. The Fed will now probably pause for a period and wait to see the effects of the easing on output. They will have been encouraged by today's jobs report, which was stronger than expected. Earnings have been good overall, although from a low expectation base. A continuation of this trend could take spreads even tighter.
