Wednesday, July 23, 2008

Sort of good news is very good news (of a sort) in markets for the moment

While the sizzling summer heatwave continues without abate around the globe, financial temperatures have decreased in the last few days. The US stock market indices, hitting official bear market territory last week, have managed to pull back as the VIX index, the so-called Wall Street’s fear gauge (a measure of the volatility of US stock prices), has retreated as well. Perhaps the most eye-catching development has been the rapid fall in the price of oil, to around $130 from last week’s peak of $147. Yet just one week ago, with bank stocks collapsing, oil prices reaching new peaks, the dollar falling to record levels against the euro and US government-backed mortgage institutions on the way to collapse, the world seemed to be once more going towards financial meltdown. This sudden turnaround, in turns, begs for answering the following questions: 1. What is behind the latest positive mood? 2. Are we finally seeing the beginning of the end of the liquidity cum credit cum financial crisis, as Deutsche Bank CEO Joseph Ackerman stated over the weekend or is the latest relief a temporary phenomenon like a summer rain and even hotter days are ahead for the financial landscape?

The answer to the first question is likely to be helpful in tackling the second, so let’s try to justify the recent positive mood in financial markets. A casual look at the last couple of weeks reveals that there was no major data release or market-mover event after the always-watched US payrolls data at the beginning of the week. We did learn that European economies are slowing down and US house prices are continuing to fall, but not anything to justify the positive moods in markets. On the contrary, as Wall street started to report earnings in the second half of week, markets had embraced the worse. However, the banks’ performance, while way from being stellar (or even mediocre), turned out to be better than expected, with the Bank of America being the latest bearer of “good bad news”. Moreover, unlike Japan in the 1990s, where banking problems ebbed on for a good 15 years, Wall Street is showing its resolve to clean its house. Not only banks are taking solid steps in getting rid of their dead assets, they are also working hard to cut costs, such as limiting their executives use of private jets’ (those Merrill executives have my deepest sympathy). The bottom line is that the market perception, supported by facts, is that banks are moving in the right direction.

In fact, there are other signs that the storm may finally be passing. While everyone has their own indicator of financial strain, the Princeton economist (New York Times columnist, prolific author and die-hard Democrat) Paul Krugman prefers the TED spread, the difference between yields on Eurodollar interbank loans (LIBORs) and US Treasuries. After falling from April to mid-June, as credit tensions eased, the spread shot up after the collapse of Bear Sterns, reaching 145bp early last week before starting to ease again since then. Moreover a chartist approach (the so-called technical analysis, the mere mention of which is likely to lead to crucifixion by the economics profession, which tends to dismiss such analysis as witchcraft) reveals that the spread has peaked five time since the summer of 2007, with each peak lower than the previous. So, maybe we are on the road to salvation.

However, it is way too early to declare that we are out of the woods. First, house prices are continuing with their downward spiral in the US. Unless house prices stabilize, we are likely to see more banking woes and credit strains. While the slack in US wages is a boon to inflation, it is one of a long line of indicators hinting that US Main Street is likely to feel the effects of the crisis once the effect of the recent tax rebates wears off. And perhaps most importantly, even if it is maybe on the way to recovery, the US financial system is still fragile; maybe a couple of “bad good news” is all the market will need to be painfully reminded once again of that unfortunate fact.

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