Are Credit Markets Back to Normal Now?

The credit markets have markedly improved since the March bottom of the S&P 500. This development is significant because it is likely to boost banks’ profits, helping them to exceed analyst expectations in the coming quarters and to raise capital independently. That, in turn, will enable the Treasury department to start withdrawing its TARP money from the banking industry.

There are several signs of this improvement:

One, secondary market liquidity has improved. The TALF program triggered an increase in debt issuances and caused their spreads to tighten.

Second, TED spread has compressed (see chart below). TED spread is the price difference between 3-month T bills and 3-month Eurodollars. It is a historical indicator of credit risk: as default risk is decreasing, the TED spread declines because T bills are considered risk free, while the Eurodollar reflects the credit ratings of corporate borrowers. Note that from a peak of 4.6%, the spread is now down to a typical, pre-panic level of 0.6%. This is a positive sign that credit markets are functioning normally again.

Third, high yield bonds are rallying, as shown in chart of high yield bonds below, another sign of liquidity and confidence returning:

Another noteworthy point: the S&P 500 five year average earnings yield is now about 4 percentage points higher than the yield of ten year government bonds.

The difference between the earnings yield and the bonds yield has historically been a good benchmark for value, because of the constant trade off between them (if you can get a better return by owning guaranteed government bonds, you wouldn't buy stocks, which are not guaranteed but do grow their earnings over time). That difference was the largest (7%) at the market’s bottom in March (meaning S&P 500 stocks were cheapest compared to bonds), and it is now still much larger than other major bottoms, including the generational bottom of October 1974.

Credit markets may not be completely healed, but they are in much better shape than they were three months ago.

Comments

[2houndz:]

We seem to all caught up in whether credit markets are working on a technical level, and making sure they work from a supply level, but they don't appear to be working on a demand level, and there doesn't seem to be anything that any government agency can do about it.
RBS is announcing that they haven't doled out the loans expected by their bailout program, but it is not due to unwillingness or lack of trying on their part. It seems that consumers don't want this 'sufficient amount of lending'. They are hesitant to hit again the bottle of poison that screwed up their lives in the first place. This reinforces (to me at least) that deflation is a slow moving train wreck that we can do little to alter. A VERY slow moving train wreck.

May 24 07:59 AM

[dcb:]

Until the Fed and government are able to withdraw support and the markets function on their own the question is mute.

May 24 10:31 AM

[Blackeyebart:]

Why would one expect the economy to come right until it stops sinking? Many signs suggest that the immediate decline is slowing down but the recovery is still some time away.

How could credit markets come right in such a climate? Good people are losing their homes, their jobs, their health Insurance. As a lender one has to be more cautious in such times. A young chap with a good job in GM's marketing division, will find it harder to get a mortgage.

The economy may need banks to start lending again, but that won't happen until reality changes. When it is safe and profitable to lend, Banks will lend.

May 24 08:21 PM