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Credit Insights

Take Cue From the Short-Term Funding Markets

Greater access to short-term funding and additional liquidity among financial counterparties will be the true testament as to the validity and credibility of the stress tests.

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The long-awaited European bank stress test results have been released, leading to a rally in both the U.S. credit and equity markets. Seven of the 91 European banks examined failed the test (one German bank that is already nationalized, one Greek bank, and five Spanish savings banks) and will need to raise a total of EUR 3.5 billion of capital. The results were better than market expectations, which reportedly anticipated more banks to fail and require significantly more new capital.

While the initial reaction in the European credit and equity indexes will be instructive as to the market's assessment of the stress test, we believe the key indicators will be the European short-term funding markets. Greater access to short-term funding and additional liquidity among financial counterparties will be the true testament as to the validity and credibility of the stress tests. Since the sovereign credit crisis began in earnest, three-month euro LIBOR, repo rates, and European commercial paper rates have steadily risen. In fact, the three-month euro LIBOR rate is 0.88%, which is as high as it was in August 2009. If the rise in short-term rates reverses its trend and the Spanish banks are able to access the short-term funding markets, we would expect the credit markets to rally back to the levels seen in late March. We also would expect credit spread tightening in Europe to outperform the U.S.

However, if short-term rates continue their upward trend and the Spanish banks stay locked out of the short-term funding market, we would expect credit spreads to widen to the levels of early June. In this instance, as credit spreads widen, we expect European issuers to continue to underperform their U.S. comparables.

The credit markets had a positive tone last week as second-quarter earnings have generally been very upbeat and management guidance has been optimistic. For example, Morningstar equity analyst Adam Fleck says he believes results from  Caterpillar(CAT), rating: A-) and  3M(MMM), rating: AA) put any worries of a double-dip recession to rest.

Morningstar's associate director of economic analysis, Bob Johnson, believes corporations will begin to step up their spending to meet demand, which will require new hiring and lead to spending growth. However, indicative of Fed chairman Ben Bernanke's "unusually uncertain" economic outlook, we note that the economic releases of late have been exhibiting an slowdown from earlier this year.

As we warned, jobless claims last week were not indicative of an improved run rate because of the July 4 holiday. This past week, claims rose to 464,000. In addition:

  • Leading economic indicators fell 0.2% in June (excluding the interest rate spread, the index would have declined 0.6%)
  • June housing starts declined to a 549,000 annual rate, a 5.8% decline versus last year
  • June existing home sales were better than expected at a 5.37 million annual rate but still declined 5.1% from last month and revealed an increase in inventories to 8.9 months from 8.3 months
  • The housing market index fell 2 points in July to 14 as homebuilders reported weakening conditions.

Whether additional activity from the private sector will be able to take up the slack from waning government stimulus remains the crux of the economic transition from a deficit-funded recovery to a self-sustaining recovery.

The new issue market was active this week as issuers took advantage of the market's risk appetite. We expect another full week of new issue supply as issuers tap the market before August, when the credit market typically slows.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.