Houghton and Atkeson

Credit Markets Point to Upturn

by Houghton and Atkeson   05/26/09

What the Markets Are Saying

We appear to be in a trading range marked on the high side by S&P 500 (SPX) 940 and 880 on the low side. The credit market, which has proven to be the most reliable early indicator of equity direction during this financial crisis, suggests that we will break out of the trading range to the upside.

The elephant in the room has shifted its weight.

During this financial crisis, the government transferred billions of dollars of toxic debt from the private sector to the public sector. With the U.K. debt outlook being downgraded to negative and the comments by Pimco's Bill Gross during an interview on CNBC about U.S. debt (Treasuries) eventually being subject to a similar downgrade, investors began to pay attention to a trend that has been in place for the past 18 months.

The advantage of keeping non-performing debt in the private sector is that it's usually written-off through a bankruptcy proceeding. Having Chrysler go through a bankruptcy process allows for the company to write-off a huge amount of debt, recapitalize and emerge as a much healthier company.

The Chrysler bankruptcy, which essentially was a victory of bondholders over government efforts to intrude and rewrite the rules, may be the catalyst that caused private capital to resume trading in the private credit sector.

Rather than allow the private economy to eliminate its losing positions and invest in its winners, the government has massively intervened by using taxpayer dollars to rescue huge portions of the financial sector, including American Insurance Group (AIG), Fannie Mae (FNM), Freddie Mac (FRE), Bank of America (BAC), Citigroup (C), etc.

The obligations the government assumed on the taxpayers' behalves take the form of Treasury bills. The T-bill is considered a riskless asset because the Treasury can print money and the United States is the leading free economy in the world. A downgrade of U.S. sovereign debt would essentially turn the world upside down.

It is unclear how the United States is going to work its way out from under its debt burden without causing higher inflation and taxation. Both of these expected consequences are long-term negatives but it is far from a certainty that they will come to pass.

Today's Trading Landscape

Earnings Before Market Open: Giant Interactive, Aladdin Knowledge, BMO Financial, Cellcom Israel, Canadian Solar, Hearst-Argyle TV, Rediff.com, Shiloh Industries.

During market hours, TrustCo Bank will issue its earnings report.

Earnings After Market Close: Borders Group, CNinsure, Coca-Cola Bottling Company, Donaldson, Design Within Reach, eLong, The9 Ltd., Noah Education Holdings, Retail Ventures, Terremark Worldwide, Take-Two.

On the economic front, U.S. consumer confidence (May measurement) will be reported. The consensus estimates for this is 42.3. The Richmond Fed and Dallas Fed release their May numbers, which are expected to be negative 6% and negative 22% respectively.

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