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Credit spread update

Credit spreads continue to decline, and that is very good news. As both charts show, spreads have reversed all of the rise that occurred in 2008; in that sense, the Panic Recession of 2008 is now a distant memory. But as the second chart shows, spreads are still at levels that prevailed prior to and during the 2001 recession. So things have improved dramatically, but the market is still priced to some grim expectations.

The fact that credit spreads are still historically high tells me that the U.S. capital market is still a long way from being overly exuberant. In the past year the market has gone from anticipating a record-breaking depression and deflation, to now anticipating a run-of-the-mill recession. Nothing out there is priced to anything like a goldilocks scenario. Take the Treasury market, where 3-mo. T-bill yields are almost zero: that can only mean that people are still deeply distrustful of the future. Or consider eurodollar futures that reflect the expectation that the Fed funds rate will rise from 0.25% today to a mere 1.0% by the end of the year. If the market had any confidence in a V-shaped recovery, expectations for the Fed funds rate at year end would be much higher.

Bottom line: if you believe as I do that the economy can manage to grow 3-4% or perhaps a bit more this year—which would amount to a fairly anemic recovery given the severity of the recent recession—then equities, corporate bonds and emerging market bonds are still offering some very attractive valuations.

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