Monday, November 10, 2008

At least one thing is almost back to normal

The turmoil in financial markets continues. The bad news is everywhere. A new President is coming, but we don't know yet what he plans to do. The equity market has been hammered. The bond market is expecting massive bankruptcies. Fear is rampant: the TED spread is still 200 bps, and the VIX is still extremely elevated (61 today). But one thing has almost gotten back to normal: 10-year swap spreads.

This is a very important first step on the road to financial and economic recovery. Note in the chart above that swap spreads started declining before the recession of 2001 hit. Spreads peaked in early 2000, well before anyone even suspected a recession was coming. They peaked at about the time that monetary policy was tightest, so tight that the yield curve was inverted (i.e., when short-maturity yields were higher than long-maturity yields). (Tight monetary policy was the cause of the 2001 recession.) Spreads hit their lows in May 2003, just before the Bush tax cuts went into effect, and just before the economy started to boom in the latter half of 2003.

Swap spreads anticipated the current crisis during the first half of last year. That they have declined significantly in the past few weeks is therefore a good indication that a healing process has begun. It may take months before any healing of the economy is obvious, but at least we know that one thing is almost back to normal. The rest should follow with time.

2 comments:

John-Paul M said...

Scott,

Give this article a once-over if you have a minute:

http://www.economist.com/opinion/displayStory.cfm?source=hptextfeature&story_id=12562343

While the main point it makes isn't mind-blowing (the connection between the brewing interest in solar and wind power and our previous eruption and subsequent near-fallout of biodiesel hype), what do you think one of the better, as I hesitate to use "best," scenarios would be regarding governmental interaction with solar development?

Best,
J-P

Scott Grannis said...

Government subsidies for any industry are a bad idea, in that we agree. But imposing huge taxes on "carbon polluters" makes sense only if we are very sure that reduced carbon emissions are going to make a significant and positive difference to the world.

I do not believe that anyone has come up with convincing evidence that links CO2 to global warming. That there exists a "consensus" that believes in the link is not science, and it falls way short of what is needed to justify a major government intervention into how our economy uses energy.

As for solar or other energy alternatives, only the market can figure out what the best solution is. I don't think we should try to force anything.