Stock Market Rally since July 15 not Confirmed by LIBOR or Mortgage Rates

Since July 15 when U.S. markets hit another intermittent low amid the ongoing credit crisis, the Dow Jones Industrials Average (Dow) has gained 7.2%. But over the same period the most important credit indices have posted declines while others have logged marginal gains. Overall, the broad trend in credit has not been bullish since mid-July, suggesting stocks are luring more investors into another bear market trap.

Since the onset of the credit squeeze last August, stocks have staged two bear market rallies – the first last September and another one in late March. Both rallies ended badly for investors. The last bear market rally following the Bear Stearns Cos. bail-out was actually supported by a broad-based decline in riskier credits; yet that 10% gain for stocks from late March through late May also proved dangerous. In June, the S&P 500 Index plunged more than 8% -- its worst June since 1930.

Nevertheless, it’s important to gauge what credit indicators are telling us now so we can at least feel more confident dipping our toes back into the stock market.

Lending rates, as defined by LIBOR, which sets the standard for over $1.5 trillion dollars’ worth of global funding remains elevated or 80 basis points above the Federal Funds target rate. The same is true in Europe where EURIBOR sits at 4.96% -- significantly above the ECB’s base rate of 4.25%. These lending rates have not eased since June and continue to paint a bad picture for global cross-border lending or the lack of inter-bank liquidity. Central banks, despite pumping the credit markets with hundreds of billions of dollars or euro since last summer, still can’t ease LIBOR or EURIBOR.

LIBOR remains my greatest concern followed by mortgage rates.

Another important barometer, U.S. 30-year fixed-rate mortgages are also trading at elevated levels and actually more than 100 basis points or 1% higher than 12 months ago. On July 17, 30-year fixed rate mortgage rates were 6.27%; on Friday they closed at 6.55%. Higher mortgage rates won’t alleviate the bear market in housing. Though stocks discount an economic recovery six months in advance, I have serious doubts housing has bottomed. The numbers still paint a horrific bloodletting in the United States.

But let’s take a closer look at the credit markets and review last week’s strong stock market action. Basically, a big rally for stocks should be confirmed by a rally in yield spreads since the risk-taking environment is improving. If investors are lunging after stocks, including the banks, then credit markets should also thrive.

Last week, the Dow gained 2.9% while the U.S. dollar had its best weekly rally in six years. Commodities prices continued to nosedive. That sort of bullish price action for stocks and the dollar should have driven non-government bonds yields sharply lower. But that was not the case.
From August 1 to August 8, ninety-day LIBOR rates climbed 1 basis point from 2.79% to 2.80%. And 30-year fixed rate mortgages climbed from 6.35% to 6.55%. Mortgage-backed securities saw a modestly lower bid while high-yield or junk bond prices declined.

The only segment of credit that posted a rally last week was investment-grade corporate debt where yields declined from 6.08% to 6.05% -- not exactly a huge gain. In Europe, investment-grade debt witnessed the best gains as bond yields declined following news that Germany’s economy contracted in Q2. That implies lower, not higher, interest rates may finally be coming in the euro-zone.

Finally, what really irks me about this rally is the Treasury market.

On big days for stocks, like last Friday, the benchmark 10-year Treasury bond posted a modest loss or a decline of 4/32nds. Typically, a big stock market rally would drive Treasury bond yields much higher as investors dump staid T-bonds for equities. Heck, if the world is chasing stocks doesn’t that suggest we’re growing more bullish on the economy? It doesn’t look that way.

The fact that T-bond yields were unchanged from August 1 to August 8 while stocks gained 3% tells me bond investors don’t believe we’re at a stock market bottom. In fact, intermediate Treasury bond prices are unchanged since July 15 as stocks have rallied. There’s something fishy about this equity market rally.

Examining credit markets is not an exact science nor is it a perfect forecasting tool. But it sure beats the stock market where crowds of neurotic and momentum-based investors chase daily trends to make a buck.

It’s still not the time to fully embrace equities. Listen to credit.

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