Sovereign Disaster: Buy what the Treasury funds, not what competes with the Treasury for funding
January 4th, 2009By David Goldman
One sector that has NOT improved during the December credit rally is sovereigns. It isn’t only the obvious weak links such as Greece and Italy, but the UK and Belgium, that remain at elevated risk levels. The on-the-run American investment CDX index tighten sharply during December, from a wide level of LIBOR +274 on Dec. 4 to +196 on Dec. 31. Not so the sovereign risks, which remain close to their early December wide levels.
Sovereign CDX Spreads vs. Investment Grade On-the-Run CDX Index
The reason for the misery of the sovereigns is obvious: the US Treasury has first call on the world’s available cash so long as the dollar remains the world’s reserve currency. Other sovereigns who made need to borrow in world capital markets to support their banking systems go to the back of the queue. I have been warning all through December here as well as here and elsewhere that other prospective Icelands lurk out there. Bloomberg reports that the UK is considering a second bank bailout and other European countries will be compelled to borrow to support their financial systems. Woe unto deficit countries when the Treasury is vacuuming up the world’s money. The Federal Reserve, to be sure, is trying to compensate for the deflationary impulse by expanding its balance sheet. Given the spectacular increase in the Fed’s balance sheet, the overall market impact is alarmingly small.
The market is punishing an external borrowing requirement more severely than war risk. The chart below compares the cost of 5-year credit protection on Israel, now in the midst of a border war, against that of Italy. Israel protection has tightened sharply from the wide level of November; Italy remains close to its wides.
Emerging markets are a mixed picture. The overall index has underperformed massively during the past several months, widenin from about one-third the spread of the high yield CDX index to the same spread.
High Yield CDX Index vs. Emerging Market Index
The emerging market index is heavily skewed upwards by a few outliers, such as Argentina and the Ukraine.
Spread to LIBOR, 5-Year Credit Protection on Selected Emerging Market Sovereigns
The main components of the EM index have tightened in common with the main credit indices. Nonetheless, the EM sovereigns remain vulnerable to the wake effect of the US Treasury’s enormous funding requirements. I continue to feel more comfortable buying the sort of things that the Treasury is helping to fund, e.g. bank debt, collateralized loan obligations, and certain categories of mortgages, than with whatever must compete with the Treasury for funding, e.g. the weaker sovereigns.
Loans are the best-performing sector of the credit market, in evident response to well-publicized purchases of collateralized loan obligation tranches by JP Morgan and other banks.
5-Year Credit Protection on CDX High Yield Index vs. Loan CDX Index
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