Key Takeaways
* One week ago we published our risk monitor with the title "Risk Cooling Off, For Now". While that didn't seem to be the case on Monday of last week, it certainly played out over the remainder of the week. This morning, we're struck most by the divergence between sovereign and bank default swaps in Spain and Italy. The strength in the sovereign swaps is reflecting the perceived progress made at the EU summit to directly recapitalize the banks. However, you'd expect to see that reflected in reduced default expectations at the banks themselves. This wasn't the case, however, as Spanish and Italian bank CDS was broadly wider last week.
* High yield rates fell sharply WoW while leveraged loan prices moved higher, underscoring the short-term momentum of the risk-on trade following last week's summit.
* Looking at the week ahead, the XLF shows more downside than upside, with 0.5% upside to $14.71 and 2.2% downside to $14.32.
Financial Risk Monitor Summary
• Short-term(WoW): Positive / 4 of 12 improved / 0 out of 12 worsened / 9 of 12 unchanged
• Intermediate-term(WoW): Neutral / 2 of 12 improved / 2 out of 12 worsened / 9 of 12 unchanged
• Long-term(WoW): Positive / 4 of 12 improved / 2 out of 12 worsened / 7 of 12 unchanged
1. US Financials CDS Monitor – In spite of the broad-based rally last week, credit default swaps among the US Financials were broadly worse. They widened at 16 of 27 major domestic financial company reference entities last week.
Widened the most WoW: MTG, LNC, GNW
Tightened the most WoW: SLM, RDN, AGO
Widened the most MoM: LNC, UNM, XL
Tightened the most MoM: SLM, RDN, WFC
European Financial CDS - The most interesting takeaway in this week's risk monitor is that the Spanish and Italian banks swaps were broadly worse week over week, while the sovereign default swaps were much tighter. Considering that the strength in the sovereign swaps was reflecting the plan to directly recap the banks through the ESM, we find it surprising that the individual company default probabilities seem not to have noticed. Overall, 22 of the 39 European financial reference entities we track saw spreads tighten last week. The median tightening was 0.5% and the mean tightening was 1.2%.
3. Asian Financial CDS- Chinese bank default swaps were wider across the board last week, while Indian and Japanese banks posted mixed results.
4. Sovereign CDS – European sovereign default swaps were tighter across the board last week. The largest moves were at Ireland (-104 bps), Spain (-72 bps) and Italy (-56 bps). There were also small moves lower at Portugal (-15 bps), France (-11 bps) and even Germany (-3 bps).
5. High Yield (YTM) Monitor – High Yield rates fell 11.5 bps last week, ending the week at 7.54 versus 7.65 the prior week.
6. Leveraged Loan Index Monitor – The Leveraged Loan Index rose 6 points last week, ending at 1660.
7. TED Spread Monitor – The TED spread fell 0.6 bp last week, ending the week at 37.7 bps versus last week’s print of 38.3 bps.
8. Journal of Commerce Commodity Price Index – The JOC index rose 1.5 points, ending the week at -15.87 versus -17.4 the prior week.
9. Euribor-OIS spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk. Last week, the Euribor-OIS spread tightened by 1 bp to 42 bps.
10. ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB. Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system. An increase in this metric shows that banks are borrowing from the ECB. In other words, the deposit facility measures one element of the ECB response to the crisis. As the chart shows, European bank reliance on the ECB remains exceptionally high.
11. Markit MCDX Index Monitor – The Markit MCDX is a measure of municipal credit default swaps. We believe this index is a useful indicator of pressure in state and local governments. Markit publishes index values daily on six 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. We track the 16-V1 series. Last week spreads widened 2 bps, ending the week at 155 bps versus 153 bps the prior week.
12. Chinese Steel - We use Chinese steel rebar prices to gauge Chinese construction activity, and, by extension, the health of the Chinese economy. We look at the average Chinese rebar spot price. Steel prices in China fell 0.61% last week, or 25 yuan/ton, to 4,050 yuan/ton. Notably, Chinese steel rebar prices have been generally moving lower since August of last year.
13. 2-10 Spread – We track the 2-10 spread as an indicator of industry net interest margin pressure. Last week the 2-10 spread tightened another 2 bps, ending the week at 134 bps.
14. XLF Macro Quantitative Setup – Our Macro team’s quantitative setup in the XLF shows 0.5% upside to TRADE resistance and 2.2% downside to TRADE support.
Margin Debt - May: +0.63 standard deviations
NYSE Margin debt fell in May to $279 billion from $298 billion in April. We like to to look at margin debt levels as a broad contrarian sentiment indicator. For reference, our approach is to look at it margin debt levels in standard deviation terms over the period 1. Our analysis shows that when margin debt gets to +1.5 standard deviations or greater, as it did in April of 2011, it has historically been a signal of extreme risk in the equity market. The preceding two instances were followed by the equity market losing roughly half its value. Overall this setup represents a long-term headwind for the market. One limitation of this series is that it is reported on a lag.
The chart shows data through May.
Joshua Steiner, CFA
Robert Belsky
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