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European credit spreads staged a dramatic rally on Tuesday ahead of a much-hoped-for US interest rate cut, and after Lehman Brothers and Goldman Sachs reassured markets with sound quarterly results.
By 1615 GMT, the Markit investment-grade iTraxx Europe index was at 133.25 basis points, according to Markit data, 24.75 basis points tighter versus late on Monday. That brought the Europe index back to levels last seen on March 6 when concerns over margin calls at private equity firm Carlyle Group drove credit spreads to fresh record highs.
The iTraxx Crossover index, made up of 50 mostly "junk"-rated credits, was 50 basis points tighter at 577 basis points. "It's the Fed and then the roll on Thursday and decent numbers from Goldman and Lehman," a London-based trader said.
The credit derivatives indexes are due to roll from series 8 to series 9 on March 20. The indexes have traditionally tightened ahead of a roll as investors close out short positions on the existing indexes in order to reinstate them on the new contracts.
But BNP Paribas credit strategist Andrea Ciccione added: "It's a proper short-squeeze, and speculators being short credit risk are just looking for the exit." Looking ahead, markets are overwhelmingly pricing in a 100-basis-point cut in US interest rates, which would be the largest one-day change since 1982.
But whilst some traders were confident that the Fed would meet expectations, strategists were more reserved. "There is a material risk that it will be less than expected and that could spoil the party," Ciccione. Five-year credit default swaps on Lehman tightened 70 basis points to 330 basis points whilst Goldman Sachs tightened 160 basis points to 225 basis points.

Copyright Reuters, 2008

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