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CREDIT MARKETS CONTINUE TO WAVE THE WARNING FLAG

CREDIT MARKETS CONTINUE TO WAVE THE WARNING FLAG

Courtesy of The Pragmatic Capitalist

Caribbean Reef Sharks

One of the primary reasons for our move to sell equities in mid-January was the warning shot the CDS market was sending.  Specifically, we said:

As the problem of debt refuses to go away and in fact, quietly spreads, we’ve seen another slow development over the course of the last few weeks – problems in Greece appear to be worse than originally expected and credit default swaps are sending warning messages again.  The term structure in Greek CDS recently inverted as investors are now increasingly concerned of a default in the next few months.  This is something we saw in 2008 before the financial markets nearly collapsed.  That time the inversion was in Lehman Brothers and Merrill Lynch CDS.

As the problems in the banking sector unfolded in late Summer 2008 the sovereign debt of the big three developed nations began to skyrocket before reaching a crescendo in early 2009.  What’s alarming with the situation in Greece is the similarities in CDS price action.  The recent uptick could be serving as a warning flag of things to come in 2010 and 2011 when the problem of debt has potential to rear its ugly head again.  Barclays might not have been too far off when they said the probability of a crisis would grow in 2010.

Well, this situation has only worsened in recent weeks and the equity markets have dipped over 5% since our “must sell” signal.  Jim Reid at Deutsche Bank is reiterating the concern we expressed several weeks ago that this is looking increasingly similar to the action in the markets heading up to the Lehman bankruptcy:

“The danger for every risk asset beyond IG credit is that if higher quality assets see forced re-pricing then it surely has to impact the riskier end of markets. The situation is increasingly reminding us of August/September 2008 when the credit market was sending out a strong sell signal to the equity market. Failing a quick sovereign bail-out, the credit markets are sending out a similar sell signal.”

Reid goes on to note that the markets appear to be accelerating what the governments hoped they could heal with time.  In essence, we’ve put all our chips on the table with the hope that our banks would earn their way out of this crisis and that the problem of debt would slowly heal itself. But as we’ve described time and time again with our comparisons to Japan, this is an incredibly risky maneuver and will ultimately result in kicking the can further down the road. The likelihood that we will ultimately solve a debt crisis with more debt is looking increasingly slim.  We’ve said it before and we’ll say it again, the classic Keynesian response of print and spend simply does not apply to this balance sheet recession.

The crisis in Europe is evolving as Greece is no longer the only concern.  Portugal now appears to be on the brink of a political crisis and the next domino in line is Spain. Spreads continue their Lehman-like action:

CDS1 CREDIT MARKETS CONTINUE TO WAVE THE WARNING FLAG

Equity investors would be wise to take note.  There is simply no reason to be taking outsized risks in such an environment.

 


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