Credit markets on the mend

The latest piece of evidence to show that credit conditions are on the mend came in this piece by Bloomberg News entitled, ‘Fierce Rally’ Under Way for Loan CDOs, Morgan Stanley Says.

The article states,

“CLOs are a type of collateralized debt obligation that pool high-yield, high-risk, or junk, loans and slice them into securities of varying risk and return. Pieces graded AA, the third highest-level of investment grade, rose from 23 cents on the dollar to 47 cents in the past month.” Bloomberg cited a report by Morgan Stanley.

The three-month LIBOR rate has fallen dramatically, and the TED spread (chart below) and the Libor-OIS spread (both measures of risk), have narrowed considerably. See Credit Markets are Finally Melting.

The three month LIBOR defines the rate banks lend to each other for three months, while the TED spread is the difference between LIBOR and the three-month T-bill. OIS (Overnight Index Swaps) are a little bit more complex but I located a great definition for those looking for the details at Learning Markets.

How does this measure risk?

The re-emergence in risk-taking is not only a clear indication that confidence is returning to the credit markets, but an signal that a Lehman style debacle or AIG bailout isn’t going to happen again.

Last September, Fannie Mae and Freddie Mac were nationalized, AIG was bailed out, and Lehman was allowed to disintegrate. Fear in the credit markets grew exponentially and a flight-to-quality ensued, driving T-bill yields to zero.

Even the normally safe three-month Eurodollar contracts, which are priced by the three-month LIBOR, were dumped as inter-bank lending ground to a halt. Funds sought all but the safest assets, such as US Treasuries, sending spreads into the stratosphere.

As the atmosphere has returned to a sense of normalcy and most traders no longer anticipate a failure of a major institution, spreads are narrowing and lending among banks is returning.

Rate hike in the near term?

The improvement in financial markets is likely to underpin economic activity. In fact, fed funds future are now pricing in a modest chance of a rate increase later this year.

In my view, we need to see an improvement in employment and positive growth in the US before the Fed will start raising rates. Bernanke and Co. do not want to be accused of short-circuiting an economic recovery by stepping on the brakes too soon.