The Data
Today’s economic data show that both initial and continuing jobless claims remain a huge drag on the economy. The survey expectation for Initial Claims was 405k…we posted 404k. The expectation for Continuing Claims was 3.710 million…the actual release was a bit lower at 3.67 million.
Are the problems in Europe fixed?
With yields rising in the Treasury market it might be tempting to believe that everything is getting better…that the sun is coming out and the rain is going away and that the Europeans are going to find a bunch of money and Germany won’t have to pay for other countries’ ability to retire early and that the flight to quality that hammered our Treasury rates is going to reverse, and that higher rates are just around the corner. It’s a feel-good story that’s easy to believe when rates improve as much as they have in the last two weeks. But is it true?
How much risk is there? The Credit Default Swap market (CDS) offers us a way to gauge market sentiment on risk. Credit Default Swaps are essentially a form of insurance. They are a contract you enter with a counter-party whereby you pay them some fees up front and an annual premium measured in basis points, and in the event of default you get your par value back. Most investors are not familiar with these instruments because they buy high quality bonds and rarely feel the need to buy “insurance” against default. The nice thing about the CDS market is that we can use levels from this arena to get a feel for risk.
A quick look at credit default swaps shows that the market is still pricing in a lot of default risk in Europe…specifically on Greek debt. As a benchmark we can look at sovereign debt from the UK…which has a CDS spread of 84 basis points. This means that market participants are willing to pay 84 bps annually to get “insurance” against default on UK bonds. If you want to buy a CDS on UK debt it would cost you roughly $8,400 per million dollars insured…not much. Germany’s CDS spread is 89 basis points...or $8,900 per million insured. These aren’t shocking numbers…there isn’t much of a premium because there isn’t much perceived risk from these issuers.
What does the market tell us about the “troubled” countries in Europe? Here is a quick list of CDS spreads on some other countries in the region:
- Spain cost 356 bps
- Italy cost 425 bps
- Ireland cost 705 bps
- Portugal cost 1097 bps
- Greece costs 5,197 bps
At a cost of 5,197 basis points this means that to get “default insurance” in the form of a credit default swap on Greek debt…it would cost you $519,700 in premiums PER YEAR to insure $1,000,000 worth of Greek debt. That is what you need to know to get a feel for how the market feels about the situation. Given that the market is still pricing in this much risk…it’s difficult for me to believe that Treasury yields are moving appreciably higher from here with this much risk still being priced into the system. For the last few months every little hiccup out of Europe has caused a big flight to safety that drove our Treasury rates lower…I see no reason why that won’t continue.
Buying opportunity
Two weeks of pullbacks in the Treasury market created a wonderful buying opportunity. The 10 year Treasury yield had gotten as high as a 2.26% for a brief moment. This morning we have a rally pushing prices higher and taking away some of the value that has been created recently. The 10-year is currently trading at a 2.13%. At the moment we can still get bonds a lot cheaper than we could two weeks ago…but the market seems to be recognizing that some of this selloff is a bit premature.
If you’ve been waiting on the sidelines for a better time to buy…this is the “better time” that you’ve been waiting for. There is a lot uncertainty in the markets, rates are at the high end of the recent range, and if you have cash you have an opportunity to buy at better levels than we’ve seen in weeks.
If you have any questions on this material just let me know.
Thanks,
Steve Scaramastro, SVP
800-311-0707
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