Wednesday, June 09, 2010

Mixing Up Liquidity Versus Solvency

I was reading Doug Kass: Mixing It Up on "Fast Money", and should conclude that indeed the technical picture in equities is stretched and oversold ... but the fundamentals are getting worse (e.g., one of leading indicators - ECRI's US WLI is dropping very fast and y-o-y growth now is barely above zero), and the "cream lickers at efficient frontiers" that 99% have devoted to the equities, may miss the difference between liquidity and solvency. Credit markets are stressed about long-term solvency, and targeting the very heart of credit markets - governments and banks (don't be fooled by short-term instruments (e.g., LIBOR) that are distorted by liquidity glut).

Jim Reid, the strategist at Deutsche Bank, notes this morning:

What is also incredible is that we now have a situation where the iTraxx Fin Snr index is only 9bp off its wides (+211bp) in March 2009. In comparison, the Xover is 531bp below its all time wides (1,163bp in March 09) and the S&P 500 and the Stoxx600 are still 57% and 52% above their March 2009 lows. We detail these differentials and those of other CDS indices in the table below.
Click on table to enlarge, courtesy of Deutsche Bank.

And Jim Reid continues:
With the dislocations seen in the table, one could argue that either Financial Senior spreads are a strong buy or the rest of the risk complex is way too sanguine about the state of the financial system. Both surely cannot be correct?. This disparity is also captured in the chart below where we have plotted the S&P 500 against the iTraxx Fin Snr (inverted) since the beginning of 2008. The two indices have generally been quite well correlated over the past 2.5 years but the recent deterioration in Fin Snr credit spreads seems to have outpaced the decline in equities. Clearly we are looking at the extreme end of things here and the relationship seems to be a CDS story for now as the iBoxx EUR Bank Sen index is about 157bp tighter than March 2009 wide of 302bp. Nevertheless the two markets are still probably at odds with each other.
Click on chart to enlarge, courtesy of Deutsche Bank.

FX strategists at BNP Paribas believe this morning:

The current share price valuation suggests that a slight stabilisation of money market spreads should lead to a good equity rebound. Hence, all eyes will be on the ECB tomorrow. A prolongation of the 3-month tender is a given and the launch of a six month tender a likely to be considered. The ECB loosing monetary conditions should allow risk appetite to rebound globally. Our trading strategy will be adjusted accordingly.

Click on chart to enlarge, courtesy of BNP Paribas.
So, this is what happens when liquidity is mixed up with solvency, but those are traders... Investors would be wise, indeed, to take note!

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