A Damascene Moment in the Markets

Financial markets appear to have had a Damascene moment on Friday evening, receiving an epiphany that has carried over into today's trading. Simply put, markets seem to have decided at some point on Friday afternoon that the dizzying array of bailouts, programs, packages and nationalizations that have been directed at the money markets is finally enough to fix the problem.

Swap spreads started to tighten aggressively on Friday p.m. and have continued to do so today. US 2 year spreads, the locus of recent madness in the funding markets, have tightened 40 bps in the last week. They remain at historically sky-high levels, so there remains ample scope for further tightening of the spread. At the same time, LIBORs are being called quite a bit lower; again, while they remain at starkly exaggerated levels relative to policy rates, it now appears as if the worst has passed and that they will continue to be marked lower moving forwards.

Tomorrow's Lehman CDS settlement remains one prominent possible thorn in the side of policy normalization. So risky markets may struggle to tack on much more upside until tomorrow's settlement is successfully resolved.

Assuming that does come to pass, Macro Man would not be surprised to see a decent rally in risky stuff. The combination of an easing of the worst of the crisis and the impending US election could give markets all the excuse they need to rally.

And there is, of course, nothing wrong whatsoever with making money on that rally. Yet once the passing of the crisis has been fully digested, where will we be left? Still staring into the jaws of a bone-crushing recession. And while US equities are certainly less expensive than they were a few months ago, Macro Man's analysis suggests that they are far from cheap.

His macro equity model, which attempts to forecast 12-month forward returns for the SPX, registered its two lowest readings in history at the end of August and September - one reason why he was happy to run short equity deltas for most of the last six-seven weeks. He has re-run the model for October, using his best guess for those inputs which have yet to officially print this month.

As you can see, while the forecast is less awful, it still ain't good. While Macro Man can see a scenario in the next six months where the outlook turns quite positive, by his reckoning we ain't there yet. Thus while Friday's Damascene moment may signal the beginning of the end of the funding crisis, there appears to be a long, hard slog ahead to convert equities into a bull market.