New Red Flag for Markets: Credit Is Tightening Again

While Wall Street enjoys its relief rally Tuesday, stocks face looming danger from a familiar foe: tightening of credit.

Several metrics that market analysts use to gauge the availability of credit have been signaling trouble in recent days, throwing up a caution flag that tougher times could lie ahead for the availability of cash.

That's a formula that always spells trouble for investors.

"Unless we start seeing a reversal of the widening of a lot of these credit spreads, any equity rally is going to be short-lived," says David Lutz, managing director of institutional trading at Stifel Nicolaus. "Unless the credit markets are cooperating, it's going to be very hard for equities to rise."

A lack of confidence in Obama administration policies, combined with unabated declines in the economy, are fueling banks' renewed reluctance to lend. And that's being reflected in a number of key data points in the credit markets.

"The euphoria over the new administration is out the window at the moment," Lutz says. "We're seeing the fact that since they haven't been able to roll out a comprehensive housing or financial program, it's a sign they don't have the right idea yet."

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Among the signs that analysts say point to credit problems are Libor, or the rate banks charge each other for overnight lending; The "Ted spread," which is the difference between 3-month Libor and the 3-month Treasury bill; two-year credit default swap rates; and the Commercial Mortgage-Backed Securities index, or CMBX.

Libor rates have swelled to prices not seen since December, with the trend indicating a June three-month rate of 1.7 percent, Lutz said in a research note. A widening in Libor emanates from lower confidence that institutions have in each other and leads to tighter lending policies. Three-month Libor gained Tuesday to about 1.33 percent.

Similarly, the CMBX and the two-year swap spread both are at four-month highs, while the Ted Spread, which indicates willingness to lend, also is moving lower, falling Tuesday to 1.09 percent.

  • Get a Full Rundown of Credit Spreads and Libor Here

None of it bodes well for the credit picture in 2009, and if credit tightens up, the stock market will feel the pinch regardless of what Tuesday's sharp rally indicates.

Stocks surged at the open on some encouraging words from Treasury Secretary Ben Bernanke regarding aid for banks in valuing distressed assets. The market punched up further following the government's decision to reinstitute the uptick rule, which requires a move higher in a stock before it can be short-sold.

"With those four things showing more and more strain, there's a disconnect with equities rallying the way they are," Lutz says. "If they keep trading this way it's definitely an indication that there could be another leg down in stocks."

To be sure, the credit indicators are nowhere near the depths of September 2008 or so when lending all but dried up completely.

But the inability of aggressive government action around the globe to eradicate credit issues is disturbing.

"After several months of swift declines and an environment where global central banks continue to cut short-term interest rates, any increase in Libor rates is a troubling reminder of the tension in credit markets," says Greg McBride, senior financial analyst for Bankrate.com. "The equity markets have effectively been behind the curve of what the credit markets have seen and experienced first-hand."

While analysts are quick to point out that the tightening is not at alarming levels at least in the short term, there's concern over the pressure the failing economy will put on lending practices.

Following a year of aggressive money-easing, Fed fund futures now are indicating a 30 percent chance that the central bank will tighten monetary policy by June.

"The underlying economy continues to deteriorate. The default rates on some of these underlying loans has been able to go up," says Mike Larson, an analyst with Weiss Research. "While they've been able to buy a period of calm, we have yet to see if it's a genuine turn and not just driven by Fed largesse."

Other indicators that have analysts concerned include the difference between investment grade bonds and Treasurys, as well as increasing problems in the commercial real estate business that will be reflected in the CMBS rates and other metrics.

Until the government can turn around the news cycle, credit issues likely will remain a significant concern.

"There's a lack of confidence and a tremendous amount of uncertainty over the fact that all the heavy artillery that the Fed, the Treasury and other central banks around the globe have been throwing at the problem has shown little impact thus far," McBride says. "Pessimism rules the day."For more stories from CNBC, go to cnbc.com.

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