Glenn - a bearish view of sharply widening credit spreads. Wide credit spreads indicate a price premium for various 'risk' factors. You don't know anybody speculating on anything risky -- do you? :)
This is from David Teece -- a 'professional bear'. The rising spreads are real, the cause is unknown. How bad is it? "Today, 10-year swap spreads traded at the widest levels in at least 10 years, surpassing even the levels during last fall's crisis."
Too Much Paper and Too Much Leverage
July 23, 1999
It was a bearish week in global financial markets from Wall Street to Seoul, from Treasury bills to junk bonds. For the week, the Dow declined 2-½% and the S&P 500 was hit harder, falling 4%. The Transports suffered only a marginal loss, while the Utilities actually gained about 1%. The bluechips outperformed, with the Morgan Stanley Cyclical and Morgan Stanley Consumer indices losing about 2%. The small caps came under selling pressure, with the Russell 2000 declining 4%. And after last week's wild speculative blow-off, technology stocks reversed Monday for their worst week in some time. The NASDAQ 100 declined 6% but still remains slightly positive for the month. The Morgan Stanley High Tech and semiconductor indices sank 8%. The Street.com Internet index suffered an 8% loss. The financials also came under significant selling pressure with the S&P Bank and Bloomberg Wall Street indices both dropping 4% this week.
The weakness in the financial stocks takes little explanation, as this week saw the return of the fixed income bear market after a brief hiatus. This week, 30-year Treasury bond yields jumped back above 6%, rising 13 basis points. Once again, even sharper losses were suffered in the "middle of the curve." 10-year Treasury note yields rose 17 basis points to 5.84%. "Off-the-run" 10-year yields rose to 5.96%. The 5-year Treasury rose 14 basis points to 5.69%. And indicative of growing systemic stress, spreads again widened this week. The "TED" spread, or the difference between Treasury and Eurodollar yields, increased 8 basis points this week to 86. The TED began the month at 62. Spreads are also increasing for the debt of the money center banks and brokerage firms, in a clear sign of heightened risk perceptions. Mortgage spreads widened as well, with the spread between the 10-year Treasury and a 7% Fannie Mae mortgage-backed security increasing 3 basis points this week to 153. One month ago this spread was 131. Spread increases are basically across the board, impacting all borrowers and asset-backed security issuers.
It also appears that there is developing dislocation in the derivatives area. Today, 10-year swap spreads traded at the widest levels in at least 10 years, surpassing even the levels during last fall's crisis. The 10-year swap spread traded today as high as 100, before closing at 98. This is an increase of 8 basis points this week and more than 30 basis points since mid-May. For comparison, the average of this spread over the past 10 years is 51. Bloomberg quoted one derivative specialist as describing the situation as "scary." With estimates placing the global derivatives market at more than $100 trillion, there is plenty reason to be scared.
At this point, the causes behind the dramatic moves in spreads and swaps remain much a mystery to the bulls that chat about the CPI and real rates of return. There is some speculation that it is related to increased international financial risk associated with a major institution in trouble, perhaps in Japan or Korea. There is also the possibility that there is a major hedge fund failing, and that other institutions are using the derivatives market to purchase insurance protection against a financial accident. We, however, will speculate that the developing crisis is more a systemic problem, unlike last year's near debacle sparked by Russia and Long Term Capital Management. In short, there is just way too much paper and too much leverage.
First, there is a staggering supply of securities that has and continues to come to market. As we have written before, since Greenspan's bailout early last October, about $1 trillion of new securities has been issued. And, importantly, the vast majority of these securities are now "under water." All the same, dealers expect record corporate issuance this quarter, likely surpassing $250 billion. There will also be a mad rush to complete asset-backed securitizations before quarter-end. Estimates have $50 billion of asset-backs to be sold this quarter. There could also be $200 billion of new mortgages that need to find buyers. The big problem is, however, that buyers are becoming more and more scarce.
For some time now, our financial system has operated as if there was an unlimited capacity to absorb new securities. Much of this absorption, however, was simply our financial system leveraging up in security holdings – creating financial credit to hold debt instruments. Last year, as we have mentioned previously, our financial sector created more than $1 trillion of new financial credit. The problem, however, is that much of this was done at much lower rates and now there are mounting losses. Moreover, not only did all this credit increase systemic risk to these highly leveraged institutions, this new credit threw too much fuel on the US bubble economy. Now too many companies are borrowing for aggressive expansion, too many new companies have joined the fray to attract capital, and the consumer, emboldened by rising stock and real estate prices, is borrowing and spending like never before, despite household savings going negative. This is clearly a recipe for trouble. Now, it looks like these unprecedented excesses have finally pushed our leveraged financial system to a breaking point. Or, at the minimum, there is building systemic stress.
We continue to suspect that the leveraged speculating community is in trouble. And actually, maybe a fitting analogy would be that many are "dying a death of a thousand cuts." So far this year, losses have been suffered on declines in the Treasury market and US fixed income instruments generally. There have also been losses on emerging market debt, and the recent losses in Argentina have likely hit some hard. Many speculators were also hurt from the weakness in the Euro and a sell-off in European bonds. And now we have what could be huge losses developing with these wider spreads. The most problematic loss, however, is likely to have occurred in the "yen carry trade." This trade faltered bigtime this week, with the dollar dropping almost 4% against the yen. If you had borrowed in Japan to hold leveraged positions in US securities, you were certainly clobbered this week. But it wasn't just the yen that caused the dollar grief. This week the greenback also lost 3% against the Euro and Swiss Franc. Actually, it was a week of general global currency instability with the Canadian dollar, Korean won, Brazilian real and Mexican peso performing even worse than the dollar.
With newfound dollar weakness and general currency instability, this only adds to the developing US financial crisis. Certainly, foreign investors will be much more cautious going forward in purchasing American financial assets and this is an important factor in faltering liquidity. And if a dollar problem does develop, it will quickly test the market's confidence in our new Treasury Secretary. Moreover, if major dollar weakness develops, liquidity medicine similar to what Mr. Greenspan administered last fall may only deepen the illness next time around. One thing is for sure, the dollar looks a lot less foolproof today than it did this time last week and these wider spreads are indicative of unfolding financial market illiquidity.
It wasn't, however, only US financial assets that had a rough week. Equities globally came under pressure. It was not a pretty week in Asia. Stocks were hit for 4% in Japan, 3% in Hong Kong, 4% in Malaysia, 5% in The Philippines, 6% in Indonesia, 7% in Singapore and 11% in Korea. Stocks fell 5% in London and Paris, and German stocks sank 6%. Closer to home, equities in Canada declined 3%, Mexico 5%, Brazil 4% and Argentina 5%. We suspect that many equity markets globally are much more vulnerable than many appreciate, and what we really have is one big fragile global stock market bubble. Whether it is leveraged hedge fund money, or heavy borrowing from Japan, or just money managers chasing performance, we believe many of the funds that have chased rising stock markets have been of a particularly speculative character. And there has certainly been a mad rush of "hot money" into Asia and Latin America. But if the crowd begins to panic, things could turn sour quickly. Certainly, with the US credit markets under increasing stress and the US equity bubble an accident waiting to happen, it is time to become much more focused on risk.
Going forward, the watchword will be liquidity. With tens of billions of new securities coming to market, it is just hard to see where the buyers will be found. And in the face of higher rates, few companies are dissuaded. In fact, 18 companies are currently lined up to soon issue about $8 billion in junk debt, this despite spreads of more than 400 basis points. But many appear to be willing to pay about any rate to get access to money. All of this paper, much of it less than stellar quality, will only put additional stress on a financial system inundated with paper and leverage. And, most importantly, higher rates and increased systemic stress are not beneficial for the US stock bubble. In this regard, this week was certainly the most encouraging in some time. Not only was the market in decline, but it almost looked like investors were beginning to differentiate between good and bad companies. Now that would be a welcomed change. It has been quite sometime since fundamentals have played much of a role in the marketplace and we are certainly excited about the developing environment.
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