All you need to know for a complete understanding of the average economist will be revealed to you in the following picture. Enjoy….
The fear of another credit crisis is receding and even though Europe’s inability to get its act together might cause days of pain we expect the risk of down 500pt DJIA move is materially diminishing.
The resteepening of BAC’s, as well as GS’ and MS’, CDS credit curves is more important than casual observers of the credit markets might realize. The inversion of BAC’s credit curve indicated that BAC was at risk of defaulting within the next year. Whether you believed BAC was truly a default risk or not, the credit market began to price in the risk that BAC could spark another LEH type event. This behavior forced the equity markets to price in the same risk. Said risk is now dissipating. (We were always more concerned with BAC’s credit risk profile than whether Italy is paying 5% or 7% on its latest bond offering.)
The stress on BAC’s credit curve profile was not limited to the CDS at its holding company level. Pricing action in subordinate BAC, BAC preferreds, as well as Legacy MER and CFC obligations (and CDS) indicated that BAC would stop paying “optional” dividends as well as jettison the MER and CFC businesses as the newly developing credit crisis got rolling. IF BAC DEFAULTED THAT IS PROBABLY WHAT THE FDIC AND FED WOULD HAVE DONE. However, as the risk of a BAC default decreases the spread differential between corp and subordinate BAC, BAC preferreds, as well as Legacy MER and CFC obligations is decreasing. Based on recent trading trends we expect this spread compression to continue.
Additionally, many causal observers of the credit markets seem to have forgotten that the credit crisis actually began when investors stopped buying structured products because of higher than expected loss rates, concerns over underwriting standards, and ultimately the value of the underwritten assets. A BUYERS STRIKE!!!THAT LASTED FOR A LONG TIME!!! These concerns are not present in the credit markets at this time, and the relative strength of the ABS market during the recent recession/credit crisis scare this summer is likely to make these concerns seem foolish. (The sell-off in RMBS securities and mortgage-REIT securities was driven primarily by expectations that the federal government would pursue policies that would artificially increase prepayment speeds, policies that would have been stupid if followed and they have since been denied.)
The inversion of BAC’s credit curve put the equity and credit of US Money Center Banks under stress. We expect the resteepening to do the opposite as well as drive the VIX under 20 again. The reopening of the debt capital markets after the labor day holiday will speed this process along.
Precious Metals Outlook: An Open Letter to a Friend by Gary Rosenthal (Principal, Rosenthal Capital Management)