Historical data, while slim, may signal tightening bottom, credit analyst says

By Ronda Fears

Nashville, April 23 - Historical data is slim to study the likes of the current credit rally, but CreditSights analyst Louise Purtle said in a report Wednesday that there is evidence that the tightening spurt may be in its final month and in the process of bottoming.

"The market has decided a back up in spreads is completely unnecessary and accelerated the pace of tightening," Purtle said in the report.

"The 90-day moving average supports maintaining longs given the momentum behind the rally," she noted, but added, "The 200-day moving average turned down in early February. In 2001, spreads bottomed within three months of this signal."

With earnings going better than anticipated, she said, another longed-for opportunity for a backup in spreads has gone begging.

The Merrill Lynch U.S. Corporate Master index now has an option-adjusted spread of 140 basis points, which she said is spread territory not seen since March 2000.

"Admittedly we were in very different yield territory then, but still the tighter spreads go, the more one looks for reassurance that remaining bullish at these tight levels is the thing to do," Purtle said.

"The OAS has tightened a further 15 bps in April alone. And the move is seeing confirmation in the default swap market.

The Goldman Sachs CDS 150 Index has tightened 14 bps over the same period and is now trading below 100 bps.

"If the market is getting nervous that this run in the credit markets can continue, it wasn't really in evidence on Tuesday, as there was such a food fight to get a piece of Wal-Mart's 10-year issue that the company was able to live up to its mantra and discount the already slim 60 bps spread that was talked about by a further 2 bps," the analyst said.

Certainly nothing in the fundamentals has stopped spreads from their inexorable march tighter, she said, but technical tools seem to indicate there is reason to expect the pace to let up.

"Technical analysis has generally not been applied to the credit markets with the same fervor that it has enjoyed in the more homogenous interest rate markets," Purtle said, "but as an observation of how the market is trading it carries the same applicability."

The 90-day moving average last crossed aggregate spreads on Nov. 6 at a spread level of 226 bps. When the spread rally paused amid pre-Iraq uncertainty in early March, she said, the two converged and came within 15 bps but did not cross, keeping the argument for a long position alive.

With that impetus behind the rally, she said, the 90-day moving average has now diverged from spreads themselves by 27 bps. In terms of duration, it has been 116 trading days since the moving average crossed. In the rally of 2001, the 90-day moving average remained above the spread level for a full 161 trading days.

"It is interesting to note that in the past six years spreads have never before moved with such impetus to tighten, even in the bull run of 2001," Purtle said.

"The only two previous periods when there was such divergence between spreads and the 90-day average was in 1998 in the wake of the Russia/LTCM crisis and in the summer of 2000 when the credit markets experienced a mini-credit crunch prior to the bursting of the tech bubble and the onset of recession.

"On both these occasions spreads were moving with momentum, but were heading wider."

The 200-day moving average gives a much more delayed signal, but also larger snapshot of market trends.

"This average typically gives such delayed signals that it is often watched more for a point at which it changes direction than when it crosses the data line," Purtle noted.

"A change in direction in this average can often indicate that a large part of a trend move has already taken place."

The 200-day moving average did not confirm the most recent buy signal until Nov. 21, she said, by which time spreads had already tightened in to 200 bps.

There have been few enough long-term rallies in credit spreads in the last six years to test this theory vigorously, she said, but one can note that in 2001 this measure turned down on May 18 when spreads where at 155 bps.

Although spreads did not definitively begin selling off till August that year, she said, they only managed to tighten another 10 bps.

"Looking at the current market, the 200-day moving average turned down on Feb. 7 when spreads were at 166 bps," Purtle said.

"Clearly, we have already well exceeded 2001's experience in terms of spread move, but we have another month to go before we breach the three-month time frame established then."

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