December 7, 2007

Credit vs Equities: tale of two markets

In time of trouble and volatility, I always look for the credit market trends for the real story. I do not usually trust the equity market performance to indicate stability or normalcy. The equity market has for the second week posted gains and corrected for more than half of the 10% drop of last month. However the credit market says otherwise.

The diverging direction of the LIBOR, interbank lending rate and the the T Bill is a sign of tight lending. Banks have no faith or trust in each other assets and that more certainly translate to commercial lending. LIBOR is 2.10 percentage point higher than the three-month Treasury bill yield of 3.05 per cent and three-month dollar Libor of 5.15 per cent. normally there is 30 basis point gap between the two rates.

Lenders have sought to buy T bills rather than lend to businesses. This indicates fear from default and the risk inherent in these businesses. Moodey's have predicted that default rates will jump next year, actually fourfold and tenfold in the event of a rescission.

Companies in distress have also risen to five-year highs in another sign of potential trouble ahead.

The Federal Reserve yesterday announced a further $23bn contraction in the size of the ABCP market to $801bn in the latest weekly data. The market peaked at $1,200bn in early August. The overall commercial paper market also contracted last week, with the outstanding total down $10.2bn at $1,844bn.

This is a vicious circle, tighter lending practices leads to defaults. Companies with no access to financing will find it hard to meet its obligation or refinance maturing debt.

While the equity market rallies, debt market is factoring in problems in the business environment.

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