A rapidly slowing European economy, driven in part by the efforts of the European Central Bank to curb inflation, has incited recent dollar strength and expectations for lower interest rates in Britain, Australia, and Europe. Concurrently, the slowdown in global economic activity has alleviated much of the supply and demand imbalance in the oil and commodities markets, leading to dramatic price declines that are reducing inflationary pressures. Consumer sentiment, which has a strong inverse relationship with fuel prices, has rebounded slightly as pressures on discretionary income have subsided. The August University of Michigan consumer sentiment index increased slightly to 61.7 from a June low of 56.4. These factors lead bulls to predict an abatement of inflationary forces and a rebound in economic growth in the U.S. While the stock market rebound has conveyed signs of optimism, credit markets continue to price significant uncertainty through higher credit and mortgage spreads and lower treasuries yields
Investment Grade Credit Spreads - 5yr CDX Index (Source: Bloomberg)
(March 10, 2007 high of 192.5 in the midst of the Bear Stearns implosion)
The growing disconnect between credit and equity market expectations suggests that there is significant disagreement about the ability of the bailout packages to address weakness in the housing and mortgage markets. Equity markets, perhaps driven by declining oil prices and strength in the dollar, have rebounded in anticipation of a trough in the current economic slowdown. Credit markets have discounted the effects of the bailout packages and predict a continued lack of liquidity as banks recapitalize. Retail mortgage rates have steadily increased, placing greater pressure on a struggling housing market. Until housing begins to rebound, no amount of bailout or stimulus packages can restore liquidity and stop the hemorrhaging of bank capital. In the mean time, expect further losses and additional bank failures to predominate along with corresponding volatility in the markets. The end, it seems, is yet to come.