A quarter for consolidation in debt markets

With the end of 2009 just about upon us, we can reflect on what a year it has been. At the start of the year the outlook for financial markets remained bleak, after the collapse of the global banking system had just been avoided in October, and the worst for stock markets was yet to come.

However, from mid-March onwards conditions in financial markets rapidly turned around and optimism that the worst had indeed past, prevailed. Significant improvement in the performance of financial markets was seen through to the end of the third quarter.

However, the recovery has, to a large extent, lost momentum in the last quarter. No doubt the recovery in financial markets had run very hard in the second and third quarters and this would be the quarter of consolidation. We have been using some key indicators to track conditions in financial markets over the course of this year and so we will again refer to these to illustrate this point.

As the global banking system was on the brink of collapse in October 2008, the TED spread (the spread between three month US Treasury notes and US dollar Libor) reflected the level of risk aversion that had entered the system, in terms of the reluctance of banks to lend to each other. A previously typical spread of around 10 basis points had blown out to 447 bps.

The TED spread started 2009 at 135 bps and by the end of September had fallen to 18 bps. It has since ranged to as high 25 bps but it has not moved any lower.

The corresponding Australian measure - the spread between the three-month overnight index swap and bank bills - was moving around in the teens in September 2009 but has spent the last quarter moving between 20 bps to 30 bps.

In credit markets, the investment grade credit default swap indices have continued to decline but the rate of decline has slowed considerably. The Australian iTraxx index peaked at 445 bps in March 2009 but had fallen to 109 bps at the end of September. It is now 23 bps lower again.

In the US, the CDX index contracted some 12 bps from its September close of 102 bps, after peaking at 262 bps. The European Main saw the least contraction in the last quarter, moving from the high 80s to 80 bps but well down from its March peak of 209 bps.

However, it should be mentioned that all the Markit indices have rolled twice since March, so there have been some compositional changes that influence performance.
Of course, a similar qualification can be made about equity market indices. The S&P 500 bottomed in March 2009 at 676.5 (the lowest close) and by the end of September had risen to 1057. Just 45 points have been added since then.

The volatility index, the VIX, moved as high as 54 points in March but had fallen to 24.6 points at the end of the third quarter. At the end of last week, it was at 21 points.

In Australia, the equity market has gone backwards since the end of the third quarter as some of the hot money has left the country. This has been echoed to some extent in the movement of the exchange rate.

The S&P/ASX 200 ended September at 4744 points but finished on Friday at 4651 points. Its closing low for the year was 3166 points on March 4.

These key indicators will reflect further improvement in conditions in financial markets in 2010 as economic growth picks up in Australia and in the major economies around the world. But the pace of improvement should be more gradual.