Wednesday, March 5, 2008

[Latest Global Dollar Liquidity measure: +11.9% annual growth rate; latest Endogenous Liquidity Index: -48.6%]

As I wrote yesterday, credit spreads are surging on a global basis. The Moody's Baa spread trades at a new five-year high of 322 basis points. Federal Reserve Governor Frederic Mishkin mentioned credit spreads on at least three occasions in his latest speech. First, he notes that corporate bond spreads are rising because investors are becoming "less willing to bear risk, more concerned about the valuations of a wide range of complex financial instruments, and more concerned about counterparty credit risk". He then notes that rising credit spreads point to a deterioration in "business sentiment" (translation: corporate profits will fall).

Finally, Mr. Mishkin notes, in the context of the housing market, that "a decline in house prices can increase the wedge between the default-free interest rate and the effective interest rate facing the homeowner. That is, in the eyes of the lenders, declining house prices diminish the quality of the borrowers' collateral, which effectively reduces the availability of credit to households that can be used to finance consumer purchases". Credit spreads, my friends, are taking center stage. Not a minute too soon! In today's Financial Times "Markets & Investing column", PIMCO's Bill Gross makes an important point about rising credit spreads:

Despite the rapid decline in Treasury yields, mortgage and corporate credit markets are not co-operating, producing aggregate price declines in total. Historically high levels of consumption as a percentage of gross domestic product are not being supported any more by leverageable assets that appreciate perpetually in price ... The American economy, so dependent on asset inflation of one sort or another, is now experiencing price deflation in all three major categories – real estate, stocks, and yes, bonds.

Even with the recent bout of price inflation in the Treasury market, rising credit spreads mean that the bond market as a whole is "deflating". While one could argue with the remark that the U.S. economy is "so dependent on asset inflation" —Bill Gross has a perma-bear-like tendency to sistematically discount the positive impact of business innovation on the economy— the point about price deflation in all three major categories is an important one.

[1] Frederic S. Mishkin: "Outlook and Risks for the U.S. Economy", Federal Reserve Board

[2] Bill Gross: "Urgent action needed to stave off rise of Bushville", Financial Times

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