Commentary

"The recent capital infusions from foreign central banks into U.S. financial companies give us confidence that this final phase of the credit crunch is underway."

The volatility in the fixed-income market that commenced in the summer accelerated through the holidays. The key themes in the fourth quarter were not substantially different from those experienced in the third quarter, including concerns about the U.S. residential mortgage market, bank exposures to opaque off-balance sheet financing vehicles, the impact of a weaker dollar and whether the resilient U.S. consumer had finally met its match. Framed in this manner, the fourth quarter represented little more than the continued playing out of the credit crunch that began in the summer: the Federal Reserve further cut the Fed funds target rate, the U.S. Treasury yield curve steepened and moved markedly lower, credit risk premiums increased significantly, and the U.S. dollar continued to drop in value. In short, the de-leveraging trade continued.

Curve Steepening
Fed rate cuts and the credit crunch caused the yield curve on U.S. government debt to steepen as short-term yields plunged.
Source: Bloomberg LP

Credit Crunch Phases

In assessing the de-leveraging trade, we prefer to deconstruct the process into three phases: valuation, liquidity and capital. Each phase overlaps to varying degrees and all three need to be navigated to work through this credit crunch.

Valuation phase. The seemingly never-ending stream of write-downs on subprime mortgages from financial institutions around the world has highlighted the valuation phase. To their embarrassment, some of the world's most sophisticated financial institutions have been forced to revalue the same assets multiple times within the same quarter. Positively, it now appears that some consensus on valuation levels is being reached. We are encouraged that actual trades have been completed for subprime-mortgage- related assets—albeit in a fire sale mode at distressed valuation levels. We are hopeful that the substantial majority of the valuation issues will be resolved as we move through the fiscal year-end reporting season. This is not to say that the valuations reported are likely to be comforting, but "better the devil you know."

Liquidity phase. The drying up of liquidity began shortly after the market recognized the difficulty in valuing subprime securities, making them difficult to trade. While market liquidity remains impaired, there are signs that the worst of the problems may be behind us. A large portion of the improvement in liquidity is due to the aggressive and coordinated activities of global central banks. The cuts in short-term interest rates in North America and the holding off on rate increases in Europe and Japan were clearly beneficial to repairing liquidity. The provision of longer-term financing vehicles by central banks has also played a key role in averting runs on banks. One of the most visible measures of this improvement in liquidity is the narrowing premium between the Fed funds rate (set by the Federal Reserve's Federal Open Market Committee) and the three-month Libor (the rate at which banks are generally willing to lend to each other).

Capital phase. The capital phase is the determination of what is left after companies determine the valuation of their assets and raise the liquidity required to hold these assets and to meet any cash flow requirements. Companies that survive the valuation and liquidity phases must determine how to best repair their battered balance sheets. In the more severe cases, this often takes the form of selling the company to a stronger competitor or raising significant amounts of new capital from equity investors. In less severe cases, this often means dividend cuts, capital spending or investment cutbacks and staff reductions. The recent capital infusions from foreign central banks into U.S. financial companies give us confidence that this final phase of the credit crunch is underway.

Economic Impact

As the systemic risks and market volatility associated with the credit crunch slowly abate, the focus shifts to the economic environment left in the wake. Unfortunately, the prize for companies that navigate their way through this credit minefield is the opportunity to be in business during what looks to be, at best, a period of sluggish economic growth. One of the most notable lingering aspects of the credit crunch will be a period of sub-par credit growth. It is important to note that the rate cuts implemented thus far by the Federal Reserve are helping to mitigate credit contraction but not yet stimulating credit growth.

Increasing Liquidity
The spread of the three-month London interbank offered rate (Libor), a benchmark for short-term yields, over the Fed funds target rate has collapsed recently, a sign of increased liquidity.
Source: Bloomberg LP

Furthermore, credit creation and the velocity of money may be negatively impacted in the near term due the substantial amount of old assets that are clogging the balance sheets of financial institutions, notably loans that were previously held off-balance sheet in structured investment vehicles, leveraged-buyout loans and commercial mortgage-backed loans. The economy must now work off the excess debt that was created during the last growth cycle before credit creation can once again be supportive influence to economic growth. The implication for the fixed-income market is that both volatility and risk premiums are likely to remain at elevated levels.

More Rate Cuts to Come

The Federal Reserve embarked upon its current campaign of interest rate cuts to protect against the risk of financial contagion. We believe this campaign will continue with substantial interest rate cuts to protect against the risks of recession. However, we must remember that one of the key ingredients to this current credit crisis was the provision of abnormally low interest rates for an extended period of time (2001 to 2003). While more interest rates cuts are on the way, we believe that the scope of these cuts should be limited to what is necessary to protect against recessionary risk and should not be viewed as a mechanism to reignite consumer spending and above-trend economic growth prematurely.

Risk Aversion
Lower government yields aided by the Fed cuts haven't resulted in lower rates on high-yield debt as investors continue to be reluctant to extend credit.
Source: Lehman Brothers, Bloomberg LP

While this more cautious campaign of rate cuts that we envision would limit the scope for a near-term rebound in the prospects for economic growth, the silver lining is that a "less-low" rate structure would be supportive to the value of the U.S. dollar and would also be a constructive influence in the struggle to moderate our persistent current account deficit. In this regard, it is important to remember that medicine is not supposed to taste good. The current campaign of rate cuts should be viewed as an opportunity to re-establish financial integrity and not as an "amuse-bouche" ahead of another feast of financial frivolity.

The result of these interest rate cuts will be a continued steepening of the yield curve, which favors shorter term maturities. We believe this steeper yield curve may help bank profitability and will accelerate the capital rebuilding process. While the rally in Treasury yields has been substantial to date, it is justified. Unfortunately, this does limit the scope of any further mark-to-market gains in the bond market from falling Treasury yields.

Conclusion: Selective Opportunities

Throughout the credit crisis, the safest place to be in the fixed-income markets has been in Treasurys and sovereign debt as nearly all forms of higher-yielding products underperformed. Given the lingering fallout from the credit crisis and the uncertain economic environment ahead, considerable caution is still warranted when allocating to higher-yielding and higher-risk segments of the fixed-income markets. This said, we believe there are selective opportunities in high-quality assets such as residential mortgage-backed securities backed by U.S. government-sponsored entities and in highly rated non-financial corporate bonds. For the riskier segments of the fixed-income market, the winter ahead likely will be long and cold.