Credit Markets: Off the Critical List? - Dead Cats Bouncing: Making Sense of the Markets

I noted in this week's podcast that credit markets were healing steadily after last Autumn's carnage, and bond issuance has picked up sharply in recent weeks. As a reflection of that trend, it is notable that after the huge ballooning of the Fed balance sheet in the last few months of 2008, several categories of Fed assets have actually declined in recent weeks. The really large changes have been in currency swaps and the Commercial Paper Funding Facility (CPFF) as shown in the first chart below. Swaps are dollars provided to foreign central banks to help satisfy dollar-based liquidity needs in foreign financial markets (recall there was a crisis shortage of dollars back in Sept/Oct as corporates in emerging markets sought to roll-over short-term debt). The CPFF is a Federal Reserve funding facility set up to boost liquidity in the domestic commercial paper markets, and as shown in the first chart, yield spreads in CP have reduced hugely since it was announced.

Ben Bernanke is on record as saying: "…when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities." Could we be starting that process? In U.S. dollar interbank lending markets, LIBOR rates have fallen substantially since the spike in yields in October/November stabilized in a narrow range in recent weeks (see bottom chart for Libor/OIS spread); term financing premia have similarly eased. As extreme deflation expectations as implied by the TIPS market have reversed dramatically, as I predicted in recent posts, (10 year implied inflation now 1.2% from zero in December), the two year/ten year spread has risen sharply to 200bp, leading to a sharply positive yield curve (beneficial for financial institutions).

Commercial paper yield spreads have also narrowed considerably for both asset-backed and financial paper since the introduction of the CPFF last fall. Significantly, large amounts of maturing paper was not reissued into the CPFF or the market in late January, possibly be a result of some borrowers shifting to other, cheaper sources of credit. Demand for funding has subsided sharply this year, perhaps because it's uncompetitive with the overlapping FDIC Temporary Liquidity Guarantee Program which guarantees financial institution debt issued up to 10 years. Agency mortgage-backed securities (ie Fannie and Freddie paper), bought by the Fed (up to the $500bn authorized by the FOMC) show up on the balance sheet at the time the trades settle. As of last week, the Fed's balance sheet had $7.4 billion in Agency MBS, although based on NY Fed figures for actual purchases made but not settled the total is closer to $92 billion. Overall, the Fed's balance sheet now seems to be contracting as capital markets sputter back into life.

There is no doubt that this will be a prolonged process, and while credit markets are off Fed life-support, they will generally remain volatile and illiquid for a sustained period. Nonetheless, even baby steps towards normalization are very positive for other risk assets given the nearly $9trn of sidelined cash in the US alone, a number rising fast with the US savings rate (already heading for 4%). The financial coronary suffered by credit markets last Summer presaged the Autumn equity crash, and recovery will equally be a harbinger of more benign conditions in equity markets.