Overall, there is more bad news than good in our risk monitor this morning. On a short-term basis, four of twelve measures deteriorated (Muni default probabilities, Chinese steel prices, yield spread, and Asia financial CDS), while just two measures improved (High yield, Euribor-OIS). On an intermediate and long-term basis, the trends remain net positive, for now. While the momentum of the market, and in Financials in particular, has clearly been higher since early June, we see storm clouds on the horizon in the form of higher commodity costs (fuel & food), lower Chinese steel prices, and tighter yield spreads.
* European bank swaps were mixed last week, with most markets showing only small changes on the margin. Meanwhile, equity prices for European financials were mostly higher.
* The high yield and leveraged loan markets both pushed higher last week.
* Municipal default risk rose again last week, as measured by the MCDX, continuing the trend that started a few weeks back when news broke that Warren Buffett cut his exposure to the muni market.
* Chinese steel in a major bear market - steel prices in China fell another 1.2% last week, or 43 yuan/ton, to 3506 yuan/ton, bringing the decline over the last four months to roughly 20%.
* The yield spread (2-10) resumes its downtrend, compressing by another 8 bps this past week to 133 bps. This barometer of bank margin pressure continues to make lower lows and lower highs.
* Our Macro team’s quantitative setup in the XLF is now Bullish TRADE and TREND, with 0.7% upside to TRADE resistance of $15.26 and 0.9% downside to TRADE support of $15.02.
Financial Risk Monitor Summary
• Short-term(WoW): Negative / 2 of 12 improved / 4 out of 12 worsened / 7 of 12 unchanged
• Intermediate-term(WoW): Positive / 7 of 12 improved / 2 out of 12 worsened / 4 of 12 unchanged
• Long-term(WoW): Positive / 8 of 12 improved / 2 out of 12 worsened / 3 of 12 unchanged
1. American Financial CDS – Swaps were broadly tighter last week for all major U.S. financial reference entities. Interestingly, this was a divergence from their equity performance, which was modestly negative.
Tightened the most WoW: GS, C, BAC
Widened the most WoW: MTG, AON, PRU
Tightened the most WoW: RDN, LNC, C
Widened the most/ tightened the least MoM: MTG, COF, GNW
2. European Financial CDS – European bank swaps were mixed last week, with most markets showing only small changes on the margin. Meanwhile, equity prices for European financials were mostly higher.
3. Asian Financial CDS – Chinese and Indian bank swaps widened while Japanese bank swaps were mixed.
4. Sovereign CDS – Spanish and Italian credit default swaps showed notable degradation last week, rising 20 and 10 bps respectively. In contrast, Portuguese swaps tightened 20 bps. The other markets we track were largely flat, though Japan widened by 4 bps (5%) to 85 bps.
5. High Yield (YTM) Monitor – High Yield rates fell 8.3 bps last week, ending the week at 7.06% versus 7.14% the prior week.
6. Leveraged Loan Index Monitor – The Leveraged Loan Index rose 4.5 points last week, ending at 1709.
7. TED Spread Monitor – The TED spread rose 1 bp last week, ending the week at 34 bps versus the prior week’s print of 33 bps.
8. Journal of Commerce Commodity Price Index – The JOC index rose 0.6 points to a new 52-week high, ending the week at -1.96 versus -2.5 the prior week. The relentless ascent of both fuel and food prices will not end well for the consumer.
9. Euribor-OIS spread – The Euribor-OIS spread tightened by 2 bps to 21 bps. 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.
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.
11. Markit MCDX Monitor – Last week spreads widened 4 bps, ending the week at 154 bps versus 150 bps the prior week. The index, which measures municipal bond default probabilities, has been trending generally higher since the news two weeks ago that Warren Buffett was reducing his exposure to the market's default risk. While the index is only making lower highs thus far, we're keeping an eye on it to see if it takes out the mid-July highs of 167 bps. 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.
12. Chinese Steel - Steel prices in China fell another 1.2% last week, or 43 yuan/ton, to 3506 yuan/ton, bringing the decline over the last four months to roughly 20%. This index continues to reflect significant weakness in China's construction market. Chinese steel rebar prices have been generally moving lower since August of last year. We use Chinese steel rebar prices to gauge Chinese construction activity, and, by extension, the health of the Chinese economy.
13. 2-10 Spread – The yield spread resumes its downtrend - last week the 2-10 spread tightened 8 bps to 133 bps. We track the 2-10 spread as an indicator of bank margin pressure.
14. XLF Macro Quantitative Setup – Our Macro team’s quantitative setup in the XLF is now Bullish TRADE and TREND, with 0.7% upside to TRADE resistance of $15.26 and 0.9% downside to TRADE support of $15.02.
Margin Debt - July: +0.61 standard deviations
NYSE Margin debt fell to $278 billion in July from $285 billion in June. We like to to look at margin debt levels as a broad contrarian sentiment indicator. For reference, our approach is to look at margin debt levels in standard deviation terms over the period 1. Our analysis finds 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 significant risk in the equity market. The preceding two instances were followed by the equity market losing roughly half its value over the following 24-36 months. 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 July.
Joshua Steiner, CFA
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