Credit: Banks And Governments In Trouble

The last time I did an update on the Credit Markets was way back in the middle of September, when majority of market pundits were extremely bearish, expecting S&P 500 to decline below a 1,000 or even back towards March 2009 lows (Articles: Credit: The Pressure Is Building & Credit: Greek Charts Of Warning). Since than the S&P 500 has recovered all the way back towards 1,290 and now trades around low 1,200s. While pessimism is still evident without a doubt, extreme negative views have diminished somewhat with majority of equity investors.

Market pundits continue to put forward strong evidence of US economic improvement, continual earnings beat rates and top margin improvements, however Credit Markets are having none of it. Plain and simple - Credit Markets are not really improving. Systemic default remains a very big risk and the contagion is spreading all across Europe now, not just throughout the infamous PIIGS.

It is difficult to be invested until some resolution occurs, because fundamentals of supply & demand or earnings are not very relevant right now. It seems majority of the money is on the sidelines waiting for a catalyst - either a default in EU or another ECB/Fed money printing program. They say a picture tells a 1,000 words, so lets get to some charts which show the elevated credit risks...

This chart above is a total disaster. Forget about the European peripherals like Greece and Portugal, we now have some big problems ahead of us. Bond investors have lost faith in some major EU countries, which include Italy and Spain. But the problem gets worse as the Core Europe is now also under attack. France and Austria has seen their funding costs skyrocket in recent weeks. This is very very dangerous stuff. On top of that even Finland and Netherlands have seen their interest rates jump to Euro-era highs. In other words, investors are now testing the whole Union as the contagion spreads from PIIGS to whole European Union.

As European Government bonds fall and interest rates rise, Credit Default Swaps are also in correlation by confirming trouble with moves to all time new highs. Spain, Italy, Belgium and France have all seen their CDS prices reach all time new highs time week. This could spell trouble ahead, unless it is backstopped.

Insurance costs on Europe corporates, including banks, also remains very elevated mimicking 2008 crisis. Credit Default Swaps on banks especially (not shown in the chart above) are all either making new highs or close to all time new highs. Banks have been and still are the main focus, as investors do not give this sector any trust whatsoever.

As already stated, investors do not trust banks and government, but the truth is that banks do not trust other banks either. As they say... wherever there is smoke, there is fire. The overnight lending rates, also known as 3 Month Libor Rates, between banks have risen without a pullback or a rest since July. Lending freeze between banks is slowly building.

The above lending freeze between banks is evident with this next chart. European banks are finding it very difficult to fund themselves in US Dollars. Since other banks are not helping, they are forced to bid up the US Dollar on the swap market. The 3 month EUR-USD swap reached almost -130 bps this week (chart only shows -125 as of earlier this week). These levels are the widest since post Lehman Brothers back in November and December 2008.

This type of credit freeze overrules fundamental outlook on earnings, commodity outlook of supply & demand and economic outlook which shows possible return to decent growth. Therefore, risk assets remain venerable until we see a catalyst or a solution to the problem, even if the can is once again kicked down the road. Rising credit spreads on corporate and junk bonds, thanks to Merrill Lynch data in the chart above, spell trouble for risk assets like S&P 500 and CRB Index, making investors pile into Treasury Bonds. If we see credit risks fall, the Treasury long trade will unwinding and cash from the sidelines will move into risk, but until than... cautious is advised.

If we overlap some of these credit readings with the S&P 500, we can see what I mean. Rising credit risk equals lower equity prices and falling credit risk equals higher equity prices. In other words, it is quite obvious that all markets are highly correlated due to fear of a sovereign default. That type of an event could than create a domino effect. Therefore, key is to keep your eye out on the credit markets, spreads and interest rates, because they seem to be "in charge" for now. A catalyst which makes Credit Markets calm down, will a signal to go back into the risk trade.