European credit spreads tightened on Friday, staging a strong end to a week in which sentiment has been lifted by a US rate cut and solid earnings from Goldman Sachs and Lehman Brothers.
Credit spreads of banks and insurance companies - which have been hit particularly hard by liquidity woes and concerns about their exposure to US subprime assets - also rallied sharply. The widely watched iTraxx Crossover index, made up of 50 mostly "junk"-rated credits, was 10 basis points tighter at 303 basis points, a trader said, having traded as low as 291 basis points earlier. That new Series 8 Crossover index has tightened some 30 basis points since its launch on Thursday.
"It's been a very strong week. Momentum is one way at the moment, stocks appear to have steadied. As long as there is no major negative big news, we should continue with the firm tone," the trader said.
"But we have seen some violence on the tightening in spreads in the last three days. They've gone far, very quickly but it's hard to call. We don't see people setting many shorts at the moment."
Meanwhile the investment-grade iTraxx Europe index was steady at 35 basis points. A bigger-than-expected 50-basis-point rate cut, delivered by the US Federal Reserve on Tuesday, helped set the more upbeat tone and was backed up by strong third-quarter earnings at Goldman Sachs in particular.
"This week's news hit the market in a very bearish positioning, explaining the immense amplitude of this week's spread tightening," said Unicredit (HVB) credit strategists in a note.
But a slump in the US asset backed commercial paper market, which shrank for the sixth straight week, is just one unsolved problem that could bring an abrupt turnaround to the new bullish mood, they added.
US data due next week, including housing numbers and durable goods, could also sway sentiment if they are way off consensus and reignite concerns about the health of the US economy.
Traders and strategists also pointed out that while iTraxx indices have rallied, cash bonds are on average trading wider on the week. In July and August, there was a positive basis between bonds and credit default swaps as people turned to the indexes to buy protection on credit. Bonds, which are more difficult to sell, outperformed the indexes into the widening, said Marcus Schueler, head of credit product marketing at Deutsche Bank.
But that basis has now turned negative, particularly as cheaper new bond issues from highly-rated corporates such as German chemical firm BASF and utility E.ON reprice existing bonds.
Increased funding costs also means that demand is not as strong as it was in the first half of the year before the market turmoil began. "People are talking about the attractive levels that the financials (CDS) are trading at, while a number of big issues are coming out now by financials. Investors increasingly regard the current level of financial spreads as an opportunity," he added.