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Credit spread update

Bearish sentiment is surging. Investors are nervous, and the prices of risky assets are down. The above charts show the impact of investors' concerns on credit spreads. While it's no fun to suffer losses on stocks and corporate bonds, what we've seen so far is in the nature of a correction, not a collapse. Credit spreads are higher and the prices of corporate bonds are lower, but it would take a lot of bad news to push spreads significantly higher. Higher spreads equate to a higher yield, and that provides investors with a cushion against further losses. Plus, as these charts show, spreads already are quite elevated relative to where they have been during times of relative calm. Translation: the market is priced for some pretty ugly news, so it makes sense to be bearish only if you are truly very concerned that the outlook is going to continue to unravel, and in a big way.

As this chart of 2-yr swap spreads suggests, the level of systemic risk is quite low in the U.S. and only moderately elevated in the Eurozone. This presents a big challenge to the bears, since U.S. swap spreads are too low to be consistent with further economic and financial market deterioration.

UPDATE: As the next chart shows, this stock market correction has been unusual since the magnitude of the selloff has not been matched by a similarly large rise in the Vix index. Combined with the low level of U.S. swap spreads this suggests that there is a lack of meaningful drivers for the selloff, and thus it may be overdone.

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