Tim Backshall produced a great chart today on investment grade (IG) credit spreads:
And while I’m at it, I’m going to shamelessly borrow some of his prose on the subject:
The 50-day average has crossed above the 200-day average and both are upward sloping.
The last time this occurred was MAY07 – that didn’t end well.
To wit, that May-07 timeframe came just before insignificant events like two Bear Stearns hedge funds collapsing, leveraged lending freezing up, and well, the proverbial poop hitting the fan. I’m not saying that caused the credit crunch, far from it. Why? Because leading indicators don’t cause events to occur, they just give you warning signs of things to come. Or they can foretell improving conditions.
At any rate, I embellished on Tim’s chart:
There are two things I want to quickly draw folks’ attention to:
First, Note the difference in spread levels between May-07 (the last time the 50 day MA exceeded the 200 day MA) and now. We troughed at roughly 75-80bps earlier this year this time around. But in 2007 IG spreads were roughly a third of that. In those infamous words of Hank Paulson’s the market has undergone “a repricing of risk.” A repricing, indeed.
Also, think about what it took to get us back to that trough. A ridiculously oversized injection of liquidity, which really is a credit easing. And what do I mean by a credit easing? This is what I mean:
The point I’m trying to make is this: typically, in a normal credit cycle, there is a period of time where loan standards are tightened quite dramatically after witnessing a deterioration in credit, followed by losses/charge-offs. It’s often said you make your best loans in the worst of times and your worst loans in the best of times.
Why? Call it a race to the bottom, if you will. Tightness in loan structures eventually give way to a relaxation of standards as economic growth occurs. By the time you reach peak economic conditions, the loans you make are probably not your best deals. These tend to blow up rather early on in a downturn. We went from virtually no deals being done over the past 2 years to doing deals like it’s late ’06-’07 again. We didn’t start with ’03 – ’04 lending standards. We started at the bottom. There’s no bottom to race to.
To me, this is an abysmal failure of Fed monetary policy. Keeping rates low has conditioned investors to go further and further out in terms of risk, but the returns they’ll get are getting squeezed.
So in other words, I doubt the “awakening” of credit markets we have seen is really one we want. In all likelihood, loans underwritten in ’09 and earlier this year are probably not much better structurally, but the pricing is richer.
And that’s supposed to make us feel better, how?