Guest Post: MJ The Credit Guru
Was Pollyanna Invited to the Party?
Risk of a European nightmare occurring has materially declined…
US Bank Credit Curve are Positively Sloped…DRAMATICALLY reducing their risk of default within the next year.
Last week we stated "….Bank equities and credit will give up this year's gains unless the bank CDS curves continue to steepen. If bank spreads do not steepen, we would expect YTD bank equity gains to dissipate….." THEY STEEPENED…. AND EQUITIES HAVE YET TO FULLY PRICE IN THIS FACT…
LOIS continues to decline as we expect it to since becoming comfortable with the ECB's 3-year facilities
The US equity market, US debt capital markets, European Sovereign Market, and Bank equity and CDS sectors continue to be driven by a "Pollyanna" sentiment that is unsustainable. The positive momentum these markets have enjoyed continues to be contingent on the belief that European & US Politicians as well as the ECB and Fed are all on the same sheet of paper and in the process of implementing successful policies that will solve the European credit crisis and improve global economic growth. This smells as if the "Big Bang Recovery" theory is generating a stronger following and a more positive sentiment than it should. Regardless of your bearish or bullish stance, it is obvious that the price performance of the major markets and key secondary market indicators are pricing the probability that a "Pollyanna" scenario is more likely than many believed at the start of the year.
One of the reasons we were concerned that last week's European downgrade would cause an increase in credit market volatility and equity market sell-off was the shape of US Money Center Bank credit curves. The CDS credit curves of BAC, GS, and MS were inverted; indicating that many credit market investors believed there was an elevated risk that European sovereign problems could generate scenarios that could cause these companies to default within the next year. An inverted credit curve is an intrinsic market statement the typically means that a company's survival is out of managements control and that the company needs to rely on outside providence to avoid bankruptcy.
If either of these companies were to default in the next year, it is likely that the following credit squeeze would be more vicious than the one following Lehman's debacle. This catastrophe risk bank credit profiles materialized immediately following the downgrade of the USA last summer, and in our opinion, was one of the primary ways that European Sovereign problems were able to influence US markets during the third and fourth quarter of 2011.
The inverted bank curves also indicated that the probability of a European credit crisis happening and spilling across the Atlantic and sending the global economy into a massive recession or depression was materially higher than the bank's credit rating agency scores would imply. Back of the envelope analysis indicated that BAC's, MS's, and GS's CDS credit curves were giving this dreadful scenario and their subsequent bankruptcy a greater than 20% probability. This indicated that the US and Global economies ability to avoid a massive recession was dependent on the survivability of three companies who the credit markets were pricing as B- rated "junk" companies.
Morgan Stanley, Bank of America, and Goldman Sach's CDS credit curves are now positively sloped. The credit markets are now treating each of these companies as investment grade companies that are very unlikely to default within the next year. This would indicate that the chance of a European crisis causing a catastrophic credit event that causes BAC, MS, and GS to default in the next year has declined from over 20% to less than 2.5% in the last month. A majority of this move occurred yesterday, and the market's ability to consolidate these gains is huge and a true game changer.
The bearish argument that this surge in risk taking is based on flawed fundamentals and incomplete European agreements is still a powerful, and likely true argument. However, as long as bank credit curves continue to steepen and rally, and that credit spreads continue to grind tighter with subdued volatility it does not make sense to add to equity short positions or avoid adding to long positions. Why credit market performance is improving is important, but making sure you enjoy the benefits of the improvements is even more important.
Despite the positive performance of the US credit markets so far this year, the gains could easily be given back if European problems cause the debt capital markets to seize or slow. However, the resteepening of bank credit curves indicates that the possibility of a European catastrophe is materially shrinking. Last week we stated "….Bank equities and credit will give up this year's gains unless the bank CDS curves continue to steepen. If bank spreads do not steepen, we would expect YTD bank equity gains to dissipate….." THEY STEEPENED…. AND EQUITIES HAVE YET TO FULLY PRICE IN THIS FACT.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.