Although the worst of the credit storm has probably passed, funding pressures for banks, companies and individuals continues, suggesting the absolute bottom has not arrived in the worst financial crisis since the Great Depression. Top-end estimates point to a $1.7 trillion dollar cleanup of the credit crisis while more conservative projections allude to a $500 billion dollar bill. Either way, it is not the time to aggressively buy into stocks.
But investment grade bonds are starting to look increasingly attractive as credit spreads start to stabilize among highly rated corporate debt instruments and Treasury bonds. It is still too early, however, for bargain-hunting in equities.
How will investors know it’s time to load-up on distressed common stocks again? Is there a set of indicators allowing prospective investors to measure credit stress?
As the bottom of this bear market eventually arrives, look to credit markets for signals that it is time to resume your buying. Bonds and credit spreads will provide a far more accurate gauge to global investors than stocks, which tend to harbor false recoveries or “sucker rallies”.
Yield Curve Inversion Warning in 2006-2007
Back in 2006, the Treasury yield curve turned negative, and successfully forecasted an economic recession. In my opinion, bonds represent the “smart money” in the financial markets and, more often than not, have historically accurately predicted economic recessions.
An inverted or negative yield curve occurs when short-term interest rates yield more than long-term rates -- an anomaly in fixed income markets that historically has preceded a slowdown or an economic recession by about 12 months. That price action, refuted by most analysts at the time, proved incredibly accurate; by July 2007, the credit markets had begun to unwind and stocks tanked, finally hitting bear market territory for the first time since 2002.
While Treasury bond inversion accurately forecast trouble ahead, that was not the case for the Dow or the S&P 500 Index.
In stark contrast, the S&P 500 Index in mid 2006 was still in bull market mode, defying the repeated warnings from the Treasury market as yield inversion grew louder. And most high risk credit markets, namely high yield or junk bonds, also continued to race higher even as the Treasury market began predicting trouble.
The Credit Crisis Checklist
The following set of indicators should accurately predict when the current credit crisis will bottom, and importantly, provide a pivotal signal to re-enter the stock market. I will elaborate on each of these indicators so you can better identify what to follow and eventually, call your broker and start loading up on equities again!
• LIBOR and SWAP rates
• Credit spreads
• Mortgage-backed securities
• Junk bond defaults
• Credit hedge fund failures
LIBOR and EURO LIBOR are important short-term overnight lending rates. LIBOR, or the London Interbank Offered Rate, has historically traded slightly above the official Federal Funds rate; Euro LIBOR has also historically traded just above the European Central Bank’s official base rate since the currency was introduced in 1999.
The difference between LIBOR and overnight interest rates set by central banks is called the SWAP rate. It’s this spread that must relax or narrow before credit markets get a “green” light.
But since last summer, when subprime problems began to boil, overnight lending rates have skyrocketed. Despite the Federal Reserve’s best efforts to lubricate the wheels of the funding markets since last summer, inter-bank lending rates remain high as institutions are reluctant to commit overnight funds to one another. And this lack of confidence among banks in the United States, Canada and Europe is spreading to Asia. As banks grow wary of lending to one another and question inter-bank collateral, the cost of funds increases exponentially, thereby slowing economic growth.
From its high last fall, U.S. dollar LIBOR SWAP rates managed to decline ahead of Christmas as the Fed and other central banks injected gobs of credit to stabilize the financial system. Since March, however, LIBOR SWAPS and its European counterpart, Euro LIBOR SWAPS, have risen markedly. This is an important signal that the credit crisis is not over. Until LIBOR SWAP rates decline and return to normal spreads above central bank monetary targets, the crisis continues.
CREDIT SPREADS are another indicator worth following closely. The spread between risk-free Treasury debt and other bonds, like corporate debt and junk bonds, is called a “credit spread.” When the economy is strong and deal-flow is rampant, credit spreads will narrow, such as what occurred heading into 2007. Junk bonds, which are below investment-grade credits, saw their yields hit historical lows versus Treasury bonds last spring – just ahead of the July subprime blowup. At the time, high yield bonds paid under two hundred basis points (2%) above T-bonds – unbelievably low. Today, that spread is just below 10% and likely to rise further as default rates climb in a recessionary economy. Until credit spreads for riskier bonds begin to tighten or narrow significantly, the economy remains on the rocks.
MORTGAGE-BACKED SECURITIES encompass a wide spectrum of instruments ranging from synthetic illiquid CDOs, or collateralized debt obligations, to bonds issued by government agencies like Fannie Mae (FNMA) and Freddie Mac. One indicator to measure the return of stability in the mortgage-backed area is to isolate a bottom in both mortgage-backed derivatives and the more conservative mortgage bonds guaranteed by FNMA. The good news is that PIMCO’s Bill Gross, the world’s savviest bond investor, has loaded up on 30-year mortgage bonds guaranteed by Fannie Mae yielding almost 2% more than Treasury bonds. That is a bullish sign that investors are returning to the safest segment of the tattered mortgage market. The mortgage-backed market still has a long way to recover and, in all likelihood, the CDO market and other synthetics tied to mortgages will probably never trade at par value again. But at some point, deep value investors will start buying some of the more liquid CDOs, and that will point to a bottom in this market.
JUNK BOND DEFAULTS typically hit a high in excess of 5% of outstanding instruments during a recession. At the moment, the junk bond default rate is under 2%, suggesting many more financially leveraged and indebted companies will head into bankruptcy or credit default. I would have to see a much higher default rate among American high yield or junk bond companies before turning bullish on the stock market.
CREDIT HEDGE FUNDS represent the largest segment of total hedge fund assets, now an estimated $2 trillion dollars. Combined with leverage, credit hedge funds are the dangerous pariahs of the investment world in 2008 as more of their investors scramble to redeem assets. Many credit hedge funds have already collapsed or have been liquidated since 2007. As assets are liquidated to meet growing redemptions, hedge funds must unwind leverage and, ultimately, abandon many positions in the credit markets that are illiquid. This will snowball into a major disaster for leveraged hedge funds in asset-backed, distressed and event driven hedge fund strategies. The end of the credit crisis will likely coincide with a major blowup at one of the largest credit hedge funds in the world. To date, the failures have mostly represented second tier or smaller industry players.
The above credit market checklist is by no means absolute, but it will serve prospective investors well ahead of a bottom in stocks and even distressed debt securities. This credit crisis will eventually pass. The worst is probably behind us for most segments of the debt markets but danger still lurks for equity investors. Tread carefully and heed the signs of credit, not stocks, for a true bear market bottom.
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