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Thursday 28 March 2024
Those of you who read my blog of the 28 February (‘Codswallop‘) will be aware of Moodys’ ongoing review of the banking sector known as the JDA – Joint Default Analysis. In this review Moodys has been upgrading banks, often dramatically, based on an expectation of state support. As my previous blog pointed out the major takeaway from the process so far was largely confusion and uncertainty. Many in the market (myself included) failed to understand how certain Icelandic banks for example could now justify a rating of Aaa (Moodys’ highest and in line with the UK government!)

However, it now seems that Moodys has been listening to the wave of criticism and has announced that they are to review the recent review. Given that Moodys’ analysts cannot yet comment on how the methodology will be modified, it is difficult to have an opinion on if the upcoming modifications will clarify the situation. Confusion seems set to remain – and as a result the cost of borrowing for these issuers is in a constant state of flux.

 

The new Adam Smith £20 note has been issued today. He is the first Scotsman to appear on a Bank of England note (our colleague Stefan would argue that this honour should have gone to Bill Shankly) and the first economist. Pictures of the new note can be found here. Whilst he was undoubtedly a free-market economist, a lot of the press coverage of the launch of the new £20 note has overemphasised this element of his work, and indeed right-wing politicians have often selectively quoted from The Wealth of Nations (1776) in order to justify the dismantling of all government activity. The "invisible hand" does indeed lead humans to create the greatest wealth for society by us acting in our self-interests, and in his most famous quote Smith stated that:

It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.

However, not only did Smith see an explicit role for the state to intervene in areas of the common good – for example, education, defence, sewerage – but elsewhere he explicitly denies that a selfish "laissez-faire" economy is desirable. The "invisible hand" doesn’t work in an absence of human "sympathy" and society. In addition he advocated progressive taxation ("it is not unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion") – again, an unpopular policy for the right-wing think tanks that have adopted Smith as their poster-boy. So an interesting and welcome choice for a banknote (we economists aren’t celebrated often enough!), but not one as straightforward as the free-marketeers would have you believe.

 

At a Chicago Business School US Monetary Policy Forum yesterday, a group of economists pointed out that if Central Bankers are setting interest rates on the basis of market and consumer expectations of inflation rates (and most, including the Fed and the Bank of England pay close attention to such surveys), they are in danger of underestimating the risks of a return to volatile inflation rates. The report, Understanding the Evolving Inflation Process, states that "neither survey nor other measures of inflation expectations provide useful forecasts of the estimated trend in U.S. core CPI inflation since the Inflation Stabilisation two decades ago". Fed Chairman Ben Bernanke obviously disagrees – he said last month that a "significant factor influencing medium-term trends in inflation is the public’s expectations of inflation", but the group of economists believe that nowadays expectations follow, rather than lead, actual inflation. As a result there is a risk that there will be no early warning signal from the carefully followed survey data, and inflation may accelerate. The economists say that Central Bankers will need to be "more vigilant". All good bond vigilantes agree.

 

We talked about the problems in the US sub-prime mortgage market back in mid February with this blog comment by Stefan. It’s worth revisiting the subject, as one of the lenders that the market had assumed was large enough to remain unaffected has announced that it’s ceasing lending. New Century, the second-largest such lender, is facing a criminal investigation in California, and is likely to breach covenants with its financial backers. The implication of the general withdrawal of liquidity from the sub-prime market – which had been 15% of the US market for home sales until recently – is that the overhang of housing inventory is likely to accelerate. Some analysts reckon that mortgage defaults may add 500,000 homes to the existing inventory backlog. In addition cancellation rates for customers who had contracted to buy new homes has risen to a massive 40%. This has to be bad news for house prices, bad news for consumer confidence, and bad news for the US economy. Also hurting will be fund managers with exposure to bonds backed with cashflows from these US mortgages – in some cases even BBB rated tranches have fallen in price by over 20%. You can follow the Mortgage Lender Implode-o-meter here.

 

Over the past few weeks, equity markets have seen falls of around 6%, and while the high yield market correction hasn’t been as severe, the iTraxx index still widened from a spread of 179/180 on February 26th to a high of 235/238 on February 28th, before clawing back some of the losses. During these turbulent times, the secondary prices traded in the European leveraged loan market remained largely stable – “rock solid” and “business as usual” according to some commentators. How has the leveraged loan market managed to remain so stable in the face of growing risk aversion?

Much of this has to do with the way loans work. As secured floating rate instruments, they are largely uncorrelated with other mainstream financial assets, providing some insulation from instability in the equity and high yield bond markets.

That said, demand continues to be incredibly strong for the asset class at present, with a clear imbalance between supply and demand (Standard & Poor’s suggest there could be aggregated latent appetite of the order of €40bn stemming from European and US CLOs, other fund investors, prime funds and repayments). This imbalance is only likely to be exacerbated by jitters in other markets, with investors seeking what they might perceive to be a ‘safe haven’ in a period of uncertainty. These factors serve to reinforce some more negative features creeping into the market – including increasingly aggressive (leveraged) transactions, and most notably downward pressure on spreads that sponsors and arranging banks are prepared to pay.

It also shouldn’t be forgotten that we are talking about the debt of sub-investment grade companies; true, leveraged loans have had a recovery rate of 80% in the event of default, which is much higher than the 40% recovery rate seen in the high yield market, but senior loans are still rated B/BB and credit default risk is therefore very real. We are therefore continuing to be very selective in choosing which new loans coming to the market we should invest in. Quality is key, more so now than ever.

Gordon Brown announced yesterday that public sector wages will increase by 1.9% this year. Within that number nurses will get 2.5%, civil servants 2%, and soldiers 3.37% – medical consultants get just 0.59%, although that is from a base of £170,000 before you get too outraged. What I found interesting from the media comment is that not one person mentioned CPI. Every commentator has focused on RPI. This quote from the Times is typical – "On average, wages in the public sector will increase by 1.9 per cent, less than half the retail prices index inflation rate of 4.2%". For the record CPI, which is what after all, the Bank of England targets, is currently 2.7%.

The unions’ focus on the "old" inflation measure is perhaps unsurprising given that it’s higher than the "new" measure, but the fact that independent commentators have yet to accept the CPI measure as the standard will be worrying for the Monetary Policy Committee. If wages, and inflation expectations, are set around the RPI headline rate, then setting interest rates on the basis of a different (and lower) inflation measure is likely to mean that monetary policy will be kept too loose to prevent an inflationary spiral. An important part of the Bank’s job over coming months therefore must be to win hearts and minds for the CPI measure. The fact is though that whilst RPI will fall back once the housing market slows, the Bank believes it is structurally about 0.5% – 0.75% higher than CPI. So if your wages are being linked to CPI rather than RPI, you are likely to lose out over the long term. An Office of National Statistics (ONS) chart showing this can be found here.

To go back to the opening question – if you got a 3% pay rise, did your real income go up or down? Well it depends on your individual inflation rate. Is your personal basket of goods more like the CPI or the RPI? For example if you are looking to buy a first home, or a bigger home, then the RPI will be more important to you as property prices are a major factor in its calculation. The ONS did produce a Personal Inflation Calculator, but as we mentioned before you need to download an SVG viewer to use it, and that’s certainly beyond me. The question is an important one though – if real incomes are rising, then UK economic growth is likely to remain at, or above trend. If they’re falling then it’s likely to herald tough times ahead for the high street and housing market.

 

In response to a recent request and the ever increasing spotlight that the iTraxx indices find themselves under I thought I’d write a quick note to try and shed some light. The indices first came into being in Europe back in June 2004 when it was felt that the bond markets would benefit from the creation of a liquid index reflecting the ever growing credit default swap market (CDS) . The index is not dissimilar to those found in the equity and traditional bond markets such as the Dow, FTSE or Merrill Lynch Bond Indices.

The iTraxx index family in Europe is principally made up of the three indices; iTraxx Europe Main, iTraxx HiVol and the itraxx Crossover. Each has its own set of rules to define which bonds are suitable for inclusion. The Main Index is composed of:
– 125 equally weighted investment grade entities,
– The HiVol 30 – the more volatile investment grade names and
– The Crossover 45 – sub investment grade names (those credits that the rating agencies believe are most at risk of default)

Each of these indices has a life of either five, seven or ten years. The indices are then created every six months (known as the roll), based on a poll which attempts to identify those bonds (subject to the criteria) that bond traders believe are most liquid and should be included (try repeating that at speed!).

The indices have proved incredibly popular amongst banks and investors alike as they offer all the benefits of a liquid instrument that enables investors to express a view on a portion of the credit markets through buying or selling the relevant index. As a result volumes have been climbing and nowadays account for a majority of trades within the credit derivatives space. Volumes this week alone are expected to be nearly €200bn!!

Until this week’s equity market sell-off we had seen nothing but an upward trending market for the indices since the previous roll back in September 2006. However, the increased volatility and price action in the equity markets has had a significant impact on the Crossover index (you’d expect this index to be the more volatile of the three) , and to a lesser degree the Main & HiVol. Interestingly so far ‘traditional’ bonds have been largely unperturbed by the increased volatility in the indices. The question many are now asking is whether the rest of the market will follow the iTraxx indices lower ?

"By the end of the year, there is the possibility, but not the probability of the US moving into recession". Former Fed Chairman Alan Greenspan used the ‘R-word’ for the second time in three days in a speech last night (I imagine Ben Bernanke’s reaction was something like "thanks a bunch"). And whilst the correction in Chinese equity markets was given as the main reason for this week’s stock market falls, I think a deeper unease at the cooling US economy is more likely to blame. Yesterday’s huge downward revision to Q4 US economic growth means that we have had sub-trend GDP in the States for 3 straight quarters now – in the new paradigm at the end of the ’90s people used to talk about trend growth being 4.5%, but the last 3 readings have ranged from a low of 2% to a high of 2.6%. The first quarter of 2007 is shaping up to be another disappointing one, and perhaps in the low end of that range. January’s housing starts fell by 17% in a month (the biggest fall since 1994) and the extent of consumer defaults in the sub-prime mortgage market has led to a sharp withdrawal of liquidity there – so I don’t expect the consumer to bail out the US economy this time round.

Bonds issued by sub-prime mortgage lenders in the US continue to get toasted. The ABX index of sub-prime asset backed bonds continues to sell off, with the BBB index trading at a yield of 15% over money market rates! This compares to about 0.8% over money market rates for a UK or European RMBS (mortgage backed bond). US mortgage backed bonds are either the buy of the century, or there’s more terrible news to come. I’m not brave enough to bet that it’s the former.

As an aside, BNP Paribas economist Richard Iley, who we mentioned in an earlier blog article when Stefan and I visited him in our New York research trip last year (and who forecast Fed Funds at 3% by end 2007), has promised not to shave again until the Fed cuts. Beardwatch starts here.

 

Month: March 2007

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