Credit: Conditions Are Improving

Introduction

The Western economies are in a secular equity bear market, where the economy is growing below trend as it is plagued by ongoing debt de-leveraging, which is constantly unsettles credit institutions, majority of which are most likely already insolvent and on zombie government life support.

Having said that... no matter how bearish you are, no matter how many books you have read on deflation, no matter how negative the media portrays the current situation in Europe, majority of the time the risk assets will not sell off significantly unless credit market conditions are deteriorating, which creates a lending freeze and ultimately derail the economy like in 2008.

Therefore, at least in my humble opinion, it is absolutely critical not to fall into a trap like so many investors have already done: becoming either perma-bearish or perma-bullish, while constantly arguing with the market on why it should be going down, while its going up and visa versa. Instead, one should listen to the market conditions and understand its message, especially if it is coming from the credit side of things. Lets have a gaze at the current conditions...

Credit Conditions

Libor OIS 3 month rates are currently falling both in the US as wells more importantly in Europe. It seems that the repeat of 2008 armageddon banking scenario was derailed and backstopped in its tracks.

The same type of a message can been from the Libor rates major private banks around the world charge each other when it comes to overnight borrowing. Conditions have started easing around a month ago, obviously linking us to the ECBs LTRO move back in middle of December.

Two year currency swap rates in both US Dollars and Euros has been falling since December 2011, similar to the Libor rates. It is important to note that the banking situation in US is definitely nowhere as bad as the European one, according to this indicator. Why do I say this? While we do have improving conditions across the board, do take note that EUR 2 Yr Swaps remain much closer to the September 2008 level, when Lehman Brothers bankruptcy sent global markets into chaos mode.

Euro Dollar Basis Swaps over a 3 month borrowing period are now also starting to improve dramatically. As we can see from the chart above, the Basis Swaps reached -150 basis points around November and December of last year. Since than, these readings have come in substantially to around -70 basis points.

Buying insurance protection against default in European institutions, through the purchase of Credit Default Swaps, has also come down significantly since the December go last year. There seems to be a similar inflection point at hand, to what has occurred between October 2008 and March 2009, when Lehman Brothers filed for bankruptcy.

Junk Bond spreads tend to signal credit contraction, increase in default rate and a potential recession. As spreads started to widen in 2011, things were looking like a repeat of 2008, however the LTRO backstop has started easing conditions here too.

Summary

It seems that every blog you visit, every technical newsletter you read and every analyst you hear on the television these days is trying to pick a top in the stock market just because it is overbought. Some traders are even getting crazy ideas that just because the stock market might top, they should also short precious metals or the Euro as "correlations" are positive.

To me this seems totally pointless, as one is trying to trade against the prevailing trend. Furthermore, it needs to be stated that this is not contrarian, as contrarians trade with the trend against the majority, while here the majority is trying to act like contrarians against the trend. Sentiment might be slightly over-bullish, however in a bull market investors are meant to be bullish. Usually a correction or a consolidation removes the short term greed and enables prices to move higher.

But more importantly, as long as credit conditions keep improving and the economy keeps chugging along, the stock market should not experience any nasty or large downside surprises. That actually goes for all the risk assets, including commodities. On the other hand, it is only when Credit Markets start bearishly diverging from the stock markets bullish direction that we should be worried. We are no where close to that yet, so for now, as credit conditions keep improving, the trend should remain your friend. Resist the temptation to pick stock market tops!