The Fed’s decision to stay on hold with interest rates is an indirect acknowledgment, despite some brave talk otherwise, that the banking system is plenty fragile (has everyone forgotten that the Fed facilities are a form of life support?) and the concomitant economic downturn may only be in its early innings.
There have been some signs of improvement. For instance, an index of the best leveraged loans has increased nearly 7% since its February low. Traffic on financial blogs is down (see here and here), usually a sign of complacency (ours is up a tad, but we aren’t as market oriented as others). And the yen continues to fall, a sign that the carry trade is alive and well, again a indicator that investors are not terribly worried about instability.
But Calculated Risk points out that the much feared TED spread is on the march in the wrong direction, and when the money markets seize up, panic usually ensues.
And the Short View column in the Financial Times, keying off adverse trends in the credit default swaps market, sounded positively anxious:
Fears are mounting that conditions are set to deteriorate markedly in credit markets.
Lehman Brothers warned this week that spreads on credit default swaps, which track the cost of insuring corporate debt against default, could soon spike beyond the levels seen at the time of the Bear Stearns rescue in March.
Spreads tightened a touch on Wednesday as the market hoped the £4.5bn ($8.9bn) secured by Barclays augured well for raising capital in the banking sector. However, the trend since mid-May has been disturbing.
The Markit iTraxx Europe index of investment-grade debt has crept back up from the recent low of 66 basis points to 96bp today. Across the Atlantic, the CDX has moved over the same period from 91bp to 130bp.
Sentiment has soured as investors have become more worried that the fallout from the subprime debacle is increasingly infecting the real economy.
A data-rich week has offered little solace. Private sector output in the eurozone has contracted for the first time in five years, while consumer confidence and housing metrics in the US continue to be dire.
Sharply rising input prices that can’t easily be passed on will further crimp business profit margins, increasing the risk of corporate failure.
Adding to the woe are more ratings downgrades for the monoline bond insurers, crucial cogs in the financial system.
So while none of this is definitive, the signs of instability are worsening. All it might take is a couple of mind-focusing bad developments in short succession for investors to start running for cover.