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Credit Insights

Where to Draw the Line in Europe?

How many sovereign defaults could occur before financial Armageddon?

Weak economic indicators, continued stress among sovereign credit issuers, and dislocations in the foreign exchange markets have been pressuring both credit and equity markets recently. The TED spread that we mentioned in our last update (an indicator of credit counterparty risk) also continued to widen last week. While the absolute spread level is still within historical norms, the rapidly rising trend is worrying. However, our concern is tempered by the fact that the range of the TED spread was 25-50 basis points before the financial crisis. LIBOR continued its ascent and ended up 6 basis points to 0.50%.

As recently as the beginning of April, European credit indexes were trading tighter than comparable U.S. indexes. However, as sovereign credit fears rose, European credit spreads began to widen faster than equivalent credits in the United States, with the European financial sector taking the brunt of spread widening. European credit indexes are currently trading at the same spread as U.S. credit indexes. The lack of transparency, and in this case, the lack of full disclosure by most European banks as to their sovereign credit exposure, led to the market selling risk in those names. We expect U.S. corporate bonds to outperform European corporate bonds as continued sovereign concerns, the weakening euro, and newly announced austerity measures will probably depress European GDP growth.