A new dawn for credit?

"It's a new dawn...and I'm feeling good". Financial markets seem to be echoing Nina Simone's sentiments in what has been a very strong start to the year for credit.

Optimism abounds as the fiscal cliff has been averted - for now - and the world's major central banks stand ready to provide support if growth doesn't pick up from its current glacial pace. Risk appetite is in vogue, as shown by the compression in the low-beta/high-beta spread differential.

The basis between the Markit iTraxx Senior Financial and the Markit iTraxx Europe is now around 20bps, the lowest since October 2010. The ECB's Outright Monetary Transactions programme has reduced systemic risk, thus making a big contribution to the tightening in banks spreads.

It should also be noted that a large skew opened up in the iTraxx Europe towards the end of 2012, and the tightening in the index this week was partly a normalisation in the theoretical basis.

Corporates took advantage of the low yields and becalmed conditions in the second-half of last year, and the paucity of returns in the high-grade space could see this trend continue in the coming weeks.

Credits based in the eurozone's periphery could be among the main beneficiaries as sovereign spreads tighten. Spain, Italy and Portugal have all seen significant tightening this week - the latter's CDS spreads on Friday hit their lowest level since October 2010.

But the eurozone is also the most likely source of a catalyst that could puncture the pervading optimism. Italy's seemingly omnipresent political instability has the potential to scupper the rally. A general election is due in February, and the outcome is highly uncertain.

The decision of outgoing technocratic Prime Minister Mario Monti to stand has reassured the markets, but the fragmented nature of Italian politics could result in a weak coalition that will find it hard to push the necessary reforms through parliament.

Spain will also be under close scrutiny this year. The country's spreads continued to tighten in January and are now at 255bps, the tightest level since July 2011. The rally over the last few months was sparked by the ECB's stated commitment to intervene in government bond markets.

But the ECB will only activate its OMT programme if the country in question has requested a bailout from its eurozone partners. Spain has so far been reluctant to do so, pointing towards the decline in its bond yields.

The markets appear comfortable with this strange state of affairs at the moment - the ECB's presence in the background makes investors reluctant to take short positions on peripheral debt.

Nonetheless, Spain has considerable funding needs this year and demand at bond auctions could falter, particularly if the poor economic performance continues. If yields start to rise then the government will be left little choice but to ask for help from its European neighbours.

We will then find out if the ECB's shock and awe tactics have removed the tail risk of a eurozone break-up and justify the strong rally in sovereign spreads. Spain's bond auction on January 10th, therefore, will be very closely watched.

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