Credit Thaw Foreshadows an Equity Rally

Feb. 8.09 | About: Financial Select (XLF)

So the bottom line is we're making loans. We want everybody to know it. I mean, we even have banners hanging on the outside of our branches, saying we're making loans. And so if you see somebody that says, they can't get a loan, give them my number.

-- Kelly King, CEO of BB&T

Despite the horrendous news on employment and corporate profits, there is some good news from the markets. Overall, the credit markets have unfrozen for all but the worst credits. I pointed some of these indicators out in September of last year after Lehman Brothers went bankrupt and they warned of the vicious beat down that stocks were about to receive. Right now, they are showing the exact opposite. Things are generally returning to normal in the credit markets. Five months after the Lehman debacle, trust is slowly being restored. Stocks should be beneficiaries of this improvement in the credit markets.

Some market observers might miss this improvement. Most of the measures of short term liquidity in the credit markets use short term Treasury securities to measure the "spread." The spread is the difference between the debt instrument, such as corporate bonds, and the "risk-free" rate, or US Government T-Bills. T-Bill rates are trading at, what I believe, are unsustainably low interest rates because of the flight to safety. In January, short term treasuries actually had a negative yield when you account for transaction costs because investors were so scared, they were happy to lock in a guaranteed loss rather than risk money in other credit instruments. The point being, if you look at any debt instrument versus Treasuries, the spread will still be indicating financial stress. But that's only because treasury securities are trading at unsustainable levels.

TED Spread

The TED spread is a money market spread that measures the difference between the three month T-bill interest rate and three month LIBOR (the interest rate at which banks lend money to each other without posting collateral). The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another.

The TED spread has returned to 1.0 or 100 basis points, which is the level at which it was trading before Lehman Brothers went bankrupt. Yet this level is still higher than pre-credit crisis, when the TED spread (the blue line in the chart below) routinely hovered at 50 basis points or below. However, it you look at the actual yield of LIBOR (the brown line in the chart below), it has returned to 2002 and 2003 levels, indicating that banks are not charging an outrageous premium to lend to one another.

TED 020609

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Source: Bloomberg

Commercial Paper

The commercial paper market shows a similar development. The commercial paper to US treasury bill spread has returned to pre-Lehman Brothers levels. However, corporations that access the commercial paper market are now paying the same low interest rate as they did in 2002 and 2003. While the spread is still elevated, the yield on commercial paper has returned to all time lows. That indicates investors are willing to accept a "normal" interest rate for the risk they are taking on. Granted, only the highest quality companies are accessing the commercial paper market but the trends are still encouraging.

Commercial Paper T Bill Spread_1020609

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Source: Bloomberg

Industrial Corporate Bonds

The corporate bond market finally perked up last week with several large deals that were well received. You can see a similar trend as in the commercial paper market. While the spread is still elevated, the interest rate for AAA corporate bonds is hovering near all time lows. Investors are willing to accept a relatively low yield for the highest quality paper. This indicates that investors are willing to pay up for high quality corporate bonds to earn a higher yield.

Corporate A Yield 020609

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Source: Bloomberg

Single A corporate bonds show a similar trend although as you might expect, the yields have not dropped as sharply as with AAA rated bonds. Investors are still willing to pay a premium for safety.

Corporate A Yield 020609

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Source: Bloomberg

The most interesting chart in corporate bonds is the yield of the lowest quality credits. While interest rates have dropped for both AAA and A rated bonds since the beginning of the year, the rates for BBB rated bonds have actually continued to increase. So while investors are flocking back to high quality credits, they are still shunning lower quality bonds. That would be normal investor behavior in a recession.

B Corp Yield 020609

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Source: Bloomberg

If you believe that the collapse in the credit markets last September led to the carnage in the stock market, then the current improvement in the credit markets has to make you bullish. The trends from the credit markets indicate that trust is returning and credit is flowing for all but the worst credits. The damage from the credit markets has obviously done serious damage to the overall economy, which might well continue to weigh on corporate earnings. However, the environment has improved, which should provide a support for stocks. A rally back to October highs of 1,000 in the S&P 500 and of S&P 1,000 and 9,500 on the Dow seem achievable.