The Debts of the World: Look to Credit Markets for Clues on Volatility in Upcoming Months

Last week, the 3 major Western central banks confirmed that we will be in a low interest rate environment for quite some time. A lot of the uncertainty leading up to their committee meetings was reflected in the CBOE's Vix which measures volatility. Specifically, the volatility reflected concerns among traders that central bankers would turn hawkish on inflation. Such fears were well founded since a slew of other central bankers had already tightened lending. Central bankers in Brazil, Australia, and the Far East had signaled a potential end to the easy money gravy train with a barrage of trading taxes, interest rate hikes, and general rhetoric about the need to restrain the flow of credit.

However, the Fed, BOE, and ECB eased such concerns with statements that basically said low rates are here to stay for at least 4-6 more months. Together, these bankers represent the vast majority of the Western capital markets.

The weekend G20 meeting (formerly the G8) also confirmed agreement among policymakers that a low interest rate environment is here to stay for the foreseeable future. The G20 meeting includes the emerging market nations which have been the main beneficiaries from a healthier credit environment.

Interest rate futures and options on futures reflect agreement about this cheap money environment. Fed funds futures reflect an uptick. Rates are calculated from 100-r, where r is the contract's value. Thus, higher futures are indicative of lower rates. Indeed, the market quotes show that (as of this time) rates will remain <1% in the US throughout 2010. This piece of information is critical as it indicates the dollar carry trade will stay w/us for a while.

Eurodollar futures also reflect near consensus about a low rate environment. The Eurodollar futures contracts covers intra-institutional lending on the commercial paper mkts (e.g. money mkts). I wouldn't be surprised to see the ED futures turn bearish slightly ahead of April-May 2010.

So, if rates are set to remain below where will the potential iceberg be?

The same place it was last year -the structured credit and secondary bond markets.

The Wall St Journal recently reported that the market for credit card backed debt is experiencing some volatility due to recent accounting rule changes.

The new rules state that banks issuing the securities must account for them as if they were on their balance sheets.

Under the old accounting standard, card issuers -- such as Citigroup Inc., Bank of America Corp., American Express Co., Capital One Financial Corp., J.P. Morgan Chase & Co. and Discover -- would package pools of credit-card loans and sell them to investors.

Until the accounting rule was changed, these securities didn't have to be included on the banks' balance sheets, so they weren't subject to the same accounting standards and disclosures required for on-balance-sheet items.

But critics argued this rule allowed companies to hide risky assets in these off-balance-sheet items. The new rule will force card issuers to bring off-the-book credit-card loans onto their balance sheets and set aside additional reserves to account for potential losses in these securities.

Another potential hurdle that banks face is the $7 trillion in short term refinancing crunch. The Financial Times reports that financial institutions are racing to refinance ahead of the G20 consensus on low interest rates.

The flood of expiring debt will hit the US and the UK hard – with $2,000bn of debt coming due by 2012 – and could curb banks’ profits or force them to charge individuals and companies more for their services.

In the US, the market for credit default swaps – a gauge of investors’ fears about companies’ health – is already signalling concern.

Tim Backshall, chief strategist at Credit Derivatives Research, said investors’ perception of risk, as measured by banks’ CDSs, was relatively low for the next three years.

But, on average, from three to five years the risk jumps about 30 per cent.

The healthiness gauge of short term debt can be read in the Eurodollar futures market (see above). Need I tell you that the liquidity driven rally is really based on short term debt? Perhaps, we can even see a return to the days of the TED spread rearing its head again in the not so distant future.