Key credit indicators still green

A typical boom-bust cycle starts with the Fed tightening monetary policy, usually in response to rising inflation and/or an economy that seems to be "overheating," or growing too rapidly. Prior to late 2008, when the Fed began its Quantitative Easing, tighter monetary policy worked by draining liquidity (i.e., by making bank reserves scarce and thus restricting banks' ability to create new loans), which in turn led to higher real borrowing costs and a general credit squeeze. Tight credit conditions and rising borrowing costs dealt a one-two punch to leveraged borrowers, and the bond market expressed this by pushing credit spreads higher as default risk rose.

We are now 2 ½ years into a Fed rate-hiking cycle: the Fed started raising short-term rates in late 2015 from a low of 0.25% to now 2.0%. Real yields have risen from -1.5% to now about zero—still very low from an historical perspective. Not surprisingly (since there has effectively been no tightening), there are still no signs of rising systemic risk or deteriorating credit conditions. Credit spreads remain low and liquidity remains abundant. Although the Fed has been draining bank reserves, they are still magnificently abundant, totaling about $1.9 trillion. 

Bottom line: the Fed "tightening" cycle looks very different today than in the past, mainly because bank reserves are still quite plentiful and real borrowing costs are still very low. 

Chart #1

Chart #2

Swap spreads, shown in Chart #1, have traditionally been excellent coincident and leading indicators of economic and financial market health. (See my primer on swap spreads for more background.) Currently, swap spreads are generally low and fully consistent with healthy financial and economic conditions. Low swap spreads are also indicative of plentiful liquidity conditions and healthy risk appetites. Eurozone swap spreads (see Chart #2) are a bit elevated, however, suggesting that conditions in Europe are not as healthy as in the U.S. Not surprisingly, we observe that the Eurozone stock market has been underperforming the U.S. by a widening margin for the past decade. But despite their being elevated, Eurozone swap spreads are not indicating a serious credit squeeze..

Chart #3

Chart #4

Chart #3 shows the spreads on investment grade and high yield (aka "junk") corporate bonds, and Chart #4 shows the difference between these two spreads. All three measures of corporate credit risk are low by historical standards, and they appear to have been improving in recent years.

Chart #5

Chart #5 shows Credit Default Swap spreads for 5-yr investment grade and high-yield corporate bonds. Credit Default Swaps are highly liquid contracts used by institutional investors to hedge generic credit risk. Here too we see that spreads are quite low.

Chart #6

Chart #7

Chart #6 compares the yield on 5-yr A1-rated industrial bonds to the yield on 5-yr Treasury yields. Both have been rising since the Fed started raising rates. Chart #7 compares the spread on 5-yr A1 Industrials to 5-yr swap spreads. Both are relatively low despite the substantial increase in yields. Note how spreads rose in advance of prior recessions, at a time that the Fed was pushing yields higher. This is further confirmation that the Fed has not been tightening. If anything, these two charts suggest we are still in the middle of what could prove to be a very long business cycle expansion.

Chart #8

Chart #8 shows the delinquency rate on all bank loans and leases, as of March, 2018. Here we see still more confirmation that rising yields have not negatively impacted businesses. Delinquency rates have been falling for almost a decade, and continue to do so.

Chart #9

Chart #9 shows the ratio of C&I Loans (Commercial and Industrial Loans, a good proxy for bank loans to small and medium-sized businesses) to nominal GDP. Here we see little if any sign of excess, and little if any indication that businesses are being unusually starved for credit.

Taken together, these key market-based indicators of credit conditions are still flashing "green." There is no sign of rising systemic or credit risk, liquidity conditions are still plentiful, and thus the outlook for the economy is healthy.

A simple fix for Argentina's peso

Since April 25th, the day the country imposed a foolish 5% tax on non-residents' holdings of Central Bank debt, Argentina's peso has lost almost 30% of its value, falling from 20 to 28. In the past year, the peso has lost almost half its value. The tax was merely the catalyst for the peso's abrupt decline, however. The real source of its persistent weakness since 2010—when the peso was trading at a relatively stable 3.8 to the dollar—is a 30% annual increase in the supply of pesos. Until Argentina's central bank stops massively printing money, the peso will continue to decline.

Why so much money printing? Because it's an easy, sneaky way of financing the government's deficit. The Central Bank effectively allows the government to spend Monopoly money in exchange for a meaningless IOU. Whoever holds pesos suffers a loss of purchasing power on an almost daily basis. That loss of purchasing power is otherwise known as an "inflation tax." The government funds its deficit by effectively robbing holders of its currency. That hits the little guy hard, and destroys confidence in the country in the process. It's hard to make significant investments in a country with a constantly depreciating currency.

Rather than own up to its shenanigans, the central bank first tried to "defend" the peso by selling one-fifth of its foreign reserves. Then the government sought $50 billion of "help" from the IMF, which it is in turn selling to further try to defend the peso. None of this has worked, of course, because it hasn't addressed the underlying problem, which is that there are way too many pesos being created. Selling a large part of your monetary base without a corresponding decline in the money supply (there has been no decline at all in Argentina's money supply for months) only facilitates capital flight. Technically speaking, Argentina's central bank has been engaging in sterilized intervention in the currency market.

In the face of a big decline in the world's demand for pesos, the only way to support the peso's value is to make a big reduction in the supply of pesos. Until that happens the peso will continue to decline over time. Sure, at some point if the peso declines enough, it will prove an attractive bet and some foreign capital will return and the peso will stabilize for a time. But it will just be a temporary respite.

Chart #1

Chart #1 is my attempt to illustrate the fundamental problem of the Argentine peso. To begin with, the supply of pesos has been increasing by about 30% per year since 2010, while the supply of US dollars has been increasing by about 6% per year. So the supply of pesos relative to the supply of dollars has been increasing by about 24% per year. That implies that the value of the peso relative to the dollar should be declining by about 19% per year, and that is shown in the green line. (Equity investors can understand this if they consider that a two-for-one stock split—a 100% increase in the number of shares—implies a 50% reduction in the price of a stock.)

Today the government announced that Luis Caputo, a man with extensive Wall Street experience, will be the new head of the BCRA. Let's hope he understands the peso's fundamental problem and promises to sharply curtail future money printing. If he does, confidence would be immediately restored and the peso could stabilize and even firm a bit. If he doesn't, then Argentina will eventually squander the IMF's $50 billion and the country will continue to suffer.

The Fed hasn't yet begun to tighten

Tomorrow we'll likely learn that the Fed is raising its target funds rate (and the rate it pays on excess reserves) by another 25 bps, to 2.0%. It won't be surprising, and it shouldn't pose any threat to financial markets. That's because this latest hike is necessary just to keep monetary policy "neutral." In fact, the Fed has been in neutral for the past year. How is that? Because the economy has been gradually picking up steam over the past year, and inflation is up as well. A modest pickup in growth and a modest rise in inflation fully justify a modest rise in rates. Indeed, it would be worrisome if the Fed doesn't raise rates tomorrow.

Chart #1

Chart #1 is an update of a chart I've been following for years. It shows that over time there is a correlation between the pace of real economic growth and real interest rates. Very strong growth (4-5%) in the late 1990s was matched by very high real yields (4%). Since then the economy has been downshifting, with growth in the current business cycle averaging a little over 2% and real 5-yr yields meandering around zero. Growth has picked up of late, however, and so have real yields. Current estimates for Q2 growth are roughly 4%, and if that proves to be the case, then real growth over the past year will have been about 3%. (The chart shows the 2-yr annualized growth rate, to better track the recent "trend" which I project will reach 2.6%.)

If growth continues to accelerate, as I expect it will (but the market is not yet convinced of this), then real yields could rise to the 2-3% range in a few years. That would of course imply a lot more Fed rate hikes than the market is currently expecting.

Chart #2

Chart #2 compares the real yield on 5-yr TIPS to the real, inflation-adjusted Fed funds target rate—which is the only rate that really matters to the markets and the economy. I've projected the real funds rate to rise to about 0.1% by the end of this month. Note that the real funds rate has been relatively stable for the past year; 3 rate hikes have been necessary simply to offset the rise in inflation.

Chart #3

Chart #3 compares the real yield on 5-yr TIPS with the "Natural Real Rate" as calculated by the Laubach-Williams method. This is "the rate interest rate consistent with output equaling potential and stable inflation." In short, it's one way of estimating what the real Fed funds rate should be if the economy is operating at or near its potential and inflation is stable. Note that 5-yr real yields (which can be thought of as the market's forecast for what the real fed funds rate will average over the next 5 years) are effectively projecting that the Fed will "tighten" monetary policy only moderately over the next several years, in a manner consistent with inflation remaining stable and the economy picking up a little speed. The Natural Rate should rise as the economy picks up speed.

Chart #4

Chart #4 compares the real funds rate with the Natural Real Rate. It's likely that the Fed keeps an eye on the natural rate, and manages the real funds rate accordingly. If they need to "tighten" policy they push the real funds rate above the natural rate, and if they need to "ease" (as they did for most of the current business cycle), then they push the real rate below the natural rate. The two lines converged in June of last year, which can be interpreted to mean the Fed decided in early 2017 that the economy no longer needed policy "stimulus," and therefore monetary policy should shift to neutral. (I'm not endorsing this way of thinking, merely commenting on how it might work.)

Chart #5

It's worth repeating Chart #5, to make the point that it takes very tight money policy to precipitate a recession. Tight monetary policy shows up in the form of very high real short-term rates and a flat or inverted yield curve. We're a long way from seeing those two conditions repeat. The current shape of the yield curve is still upward-sloping, which means only that the market expects the Fed to continue to raise short-term rates for the foreseeable future. That's not remarkable or in the least scary. Besides, real interest rates are still unusually low.

Chart #6

Chart #6 compares the nominal and real yields on 5-yr Treasuries, with the bottom line being the difference between the two, which is the market's implied forecast for what the CPI will average over the next 5 years. Happily, inflation expectations are only slightly above 2%, which is fully consistent with the Fed's objectives and fully consistent with stable inflation. If the Fed is going to hike rates significantly, we'd first have to see stronger growth and/or rising inflation expectations.

Chart #7

The CPI ex-energy, shown in Chart #7 has actually been very stable around 2% for the past 15 years. I justify taking out energy prices because they are by far the most volatile of all commodity prices, and it makes no sense for the Fed to try to control energy prices. And in the long run, there is not much difference between the full CPI and the ex-energy CPI.

Chart #8

Chart #8 shows the history of the CPI and the ex-energy CPI, using a 6-mo. annualized calculation to focus on recent trends. Note the huge amount of volatility imparted to the full CPI just by adding energy prices, even though energy represents less than 4% of personal consumption expenditures. Over the past 20 years, the full CPI has averaged 2.2% per year, while the ex-energy CPI has averaged 2.0%. 

Chart #9

One of the least-remarked developments on the inflation front is arguably the disappearance of deflation from computer prices. Chart #9 shows how prices for computers and peripherals were falling 30% per year about 20 years ago. So far this year, prices have been stable, for the first time ever.

Chart #10

One reason to expect stronger economic growth is shown in Chart #10. Small business optimism has never been higher than it is today. Entrepreneurs are excited about lower tax rates and a substantial reduction in regulatory burdens. This should translate into more investment, more jobs, and higher productivity (which has been sorely lacking during the current business cycle).

Chart #11

Chart #11, another perennial favorite, shows how every major increase in the market's level of concern and uncertainty has coincided with a sharp selloff in equity prices. Once fears subside, prices float back up. The same cycle has repeated a number of times in recent years, and we're at the tail end of the most recent.

Chart #12

Chart #12 compares the Core measure of consumer price inflation (ex-food & energy) with 5-yr Treasury yields. Normally the two should move together. That relationship broke down in 2011, however, when the market started worrying about the collapse of the Eurozone, the fiscal cliff, China, oil prices, Brexit, and the US election, successively. Risk aversion throughout most of the current business cycle drove strong demand for Treasury yields, keeping them unusually low relative to prevailing inflation. Now we're getting back to normal. Higher interest rates are not scary, they're to be expected.

I don't think the Fed is going to be a source of concern for the market for the near future. But if the economy heats up, the Fed governors are going to be wringing their hands and losing sleep at night. And if inflation expectations rise, well, then we'll all start to worry. But for now the main thing to watch is the economy, which should continue to show signs of faster growth. (See my last month's post "Waiting for GDP") If I'm right and GDP growth accelerates convincingly above 3-3.5%, then the Fed is going to have to raise short-term rates, and bond yields are going to have to rise as well, and both by much more than the market is currently expecting. Will higher interest rates kill the economy? No, because they will be the natural result of a stronger economy. Interest rates will only become a concern when the Fed thinks it needs to step on the brakes and raise real rates significantly.