Cracks in the Credit Market

This is not how it was supposed to be…

Iron ore and commodity prices continue to crash. The budget deficit is in a mess. The Aussie dollar remains stubbornly strong. Auction clearance rates are down in Sydney and Melbourne, marking an end to the big house price boom.

Sorry kids, Santa Claus isn’t coming to town. Not this year.

On Friday in the US, markets finished deeply in the red. The Dow was off 1.76%, while the S&P500 finished down nearly 2%.

The reason? Trouble is brewing in the credit markets. From the Financial Review:

The shock decision by respected Wall Street firm Third Avenue Management to shut down its $US789 million high-yield credit fund and prevent investors redeeming cash sent shudders through US markets on Friday.

Third Avenue announced to investors that its Focused Credit Fund was taking the rare step of closing and banning withdrawals from investors, until the low-rated securities are sold off in coming months.

The fund’s value has plunged from about $US2.5 billion to $US789 million, after bets on very low rated and unrated corporate debt turned sour. Underlining the lack of buyers for high yield paper and giving credence to warnings about illiquidity in bond markets, the firm has reportedly had difficulty dispensing of the securities.’

Now a sell-off in junk bonds is not particularly concerning. They are junk, after all. But it’s a worry that these assets are performing so poorly when the Fed hasn’t even started to raise rates yet.

The problem is that there was a huge amount of junk bond issuance in the post 2008, zero interest rate environment. In particular, energy producers issued a lot of them when oil prices were over US$100 a barrel.

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It’s taken a while, but investors are now starting to panic. It’s playing out just like Jim Rickards said it would. Jim’s the Strategist for Strategic Intelligence. He predicts that a huge amount of energy related debt will go bust, and spark a contagion that flows into other areas of the market.

That’s the biggest risk and biggest unknown. Will the sell-off in junk bonds infect other markets? Will people panic about the freezing of one credit fund and move to get their capital out of others?

If they do, and the Fed raises rates for the first time in a decade on Wednesday, then things could start to get interesting. As in bad…

When investors panic and move to cash, it represents a tightening of credit conditions. If done on a large enough scale, such panic can cause a classic ‘credit crunch’.

That’s because there is only so much ‘cash’ in the system. When the market panics and moves to cash, you normally see a response from the central banks, the ultimate supplier of cash to the financial system.

The idea is for the central bank to inject cash to satisfy demand…to alleviate the panic. Then, when assets prices fall enough and the panic subsides, investors see relative value. They move back out of cash and into the ‘cheap’ assets. Problem solved.

Except this time around, the Federal Reserve is about to increase rates. That effectively means it will take some cash out of the system. Not much in the scheme of things, but in an environment of tighter credit in some parts of the market, it makes the case for an interest rate rise that much riskier.

The Fed has a problem though. If it backs away from raising rates again, it could prove to be a fatal blow to its credibility. But if it raises rates in the face of these tightening credit conditions, it risks triggering a bigger panic.

My guess is that it will raise rates this week, but make sure the market understands there probably won’t be another one for a very long time.

And if this first rate hike in 10 years does cause some sort of panic, then expect the Fed to do an about face pretty swiftly. In such a scenario, you’ll want to have some precious metals exposure, because gold and silver will fly.

This is the sort of catalyst I’m looking for to launch my ‘10-bagger’ stock pick higher. The way things are shaping up, it could come sooner rather than later.

Falling commodity prices are obviously the reason behind the recent sharp falls across global markets. So it’s no surprise then that the Aussie market is back trading around a crucial, long term support level — 5,000 points on the ASX200 index.

According to the futures market, the index will open below this point today. In recent months, strong buying has come in around this level and pulled the index back up.

Whether that happens today or for the remainder of this week though is another question. Previously, the banks supported the market while the big miners took a beating. Investors favoured the banks because of the healthy yields on offer.

But now, the sustainability of those yields are in question. Can the banks (and the Aussie economy) continue to hold up while commodity prices crumble around them?

As we head into Christmas, that’s a question you’re about to find out the answer to.


Greg Canavan,

For Markets and Money

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Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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