Thursday, April 16, 2009

credit investors soon seemed to realise that ‘less bad’ news was not yet ‘good news’

TO BE NOTED: From Alphaville:

Liquidising the credit rally

The recent stabilisation in the Institute for Supply Management Index (ISM) has been hailed by some as justification for a rally in corporate credit.

Indeed, there’s historical precedence for that. Over the past 40 years, when ISM stabilises, credit spreads have tended to tighten. But, it’s important to note, that such rallies have usually been very temporary and quickly reversed. Credit markets have usually waited for manufacturing to actually expand — not just slow its slide — before pricing in a more sustainable, longer-term rally.

You can see the tendency in the charts below, from Dresdner Commerzbank. The red dots are the low points in the ISM Index and the green ones are what the bank deems sustained rallies in credit spreads.

Dresdner Commerzbank - ISM and credit charts

Here’s what Dresdner analyst Willem Sels has to say on the subject:

Every time ISM found a bottom, spreads started to come in. But in each case, credit investors soon seemed to realise that ‘less bad’ news was not yet ‘good news’, and the spread path reversed. The real sustainable spread compression started only later… It is remarkable that these ‘true’ rallies all occurred only when ISM was back above 50 again (52 in most cases – as shown on the ISM graph), i.e. when manufacturing was expanding again.

So, historically, it’s taken nine to 15 months after the troughing of the ISM for a “true rally” in credit to take hold. If history repeats itself (past performance is not necessarily indicative of future results and all that), we’re looking at September/October for a meaningful tightening in spreads — and that’s assuming that the ISM has really troughed — a rather risky premise.

Of course, you could argue that the above analysis ignores the possibility that spreads may have overshot fair value. Savvy investors could jump in now and make a short-term killing, maybe even a longer-term one. But, there’s one thing that should be giving them pause for thought and that’s liquidity.

Here’s Sels again:

One of the reasons why investors do not want to anticipate a rally too far ahead is the cost of getting it wrong. As we suggested before, even if there were scope for further spread compression, we think spreads would widen out again before starting a sustainable rally. In the current market environment, it is very difficult to get in and out at an acceptable cost (even if one were able to time it perfectly).

You can see that lack of liquidity in this chart, with trading volumes of corporate bonds still very thin.

Dresdner Commerzbank - Trading volumes

In otherwords - if you want to chase a quick credit rally - make sure you can get out swiftly.

Related links:
Any angels left in heaven? - FT Alphaville
Chief of NYSE cautious over rally in March - FT
The incredibly shrinking market liquidity, or the upcoming black swan of black swan - Zero Hedge
Merrill let loose on the quant scent - Zero Hedge

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