Tuesday, October 28, 2008

Are swaps forecasting a huge equity rally? (2)

I'm not giving up on this chart yet, especially after today's rally. The premise of the chart is that the financial market logjam which resulted in record-high swap spreads, credit spreads and the TED spread, not to mention a woeful lack of liquidity in the institutional money market, was a major contributing factor to sowing fear, uncertainty and doubt throughout world markets in general, severely depressing valuations for corporate bonds and stocks and pushing volatility (e.g., the VIX index) to record highs.

The thrust of government bailout efforts is to relieve some of this stress, and it appears that things are beginning to loosen up. Swap spreads are always the first to react to changes in systemic risk, so the rally today could be more confirmation that underlying conditions are starting to improve.

Could the rally really be as strong as the chart suggests? That sounds like a lot to hope for, but I don't think it's unreasonable to expect some dramatic improvements. To date this crisis has been mainly a financial market event, and it has only partially spilled over to the real economy. Big financial crises do not necessarily predict or foreordain economic depressions. And most importantly, equity valuations today appear to be extraordinarily depressed by fear that could be alleviated.

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