I've been touting swap spreads as a good leading indicator of the health of the financial market for years. When swap spreads fell significantly last October, I took that as a sign that the fundamentals were beginning to improve, and that financial markets in general were going to be turning up. I first showcased this chart last November, arguing that junk bonds were a steal. And indeed, junk bonds have done quite well since and look to do even better in the future.
The extraordinarily high yields and spreads on corporate debt that we saw a few months ago were telling us that the market expected something like half of all the companies in the U.S. to go bankrupt within the next five years. Driving this extremely grim forecast was the market's belief that collapsing demand would give us years of deflating prices, and that the world economy would therefore spiral downwards into a black hole worse than what we saw in the Great Depression.
As it is turning out, the reality is proving to be much less grim than the expectations. Monetary policy is extremely easy, and it is gaining traction. Bailout efforts have been massive, costly, and probably ill-advised, but they have succeeded, apparently, in restoring some measure of liquidity and confidence to the credit markets. The market has had plenty of time to heal itself. Confidence is the key ingredient to an eventual recovery from this crisis, and it is slowly returning.
To hang out in cash and earn almost nothing, while junk bonds are yielding in the double digits, requires a profound degree of pessimism. One example of how pessimistic the pundits are can be found in a NY Times Op-Ed piece two days ago. Four out of five economists could not muster even an ounce of optimism, despite all the "green shoots" of recovery. Such overwhelming pessimism is an essential ingredient for a market rally such as we have witnessed over the past month.
Full disclosure: I am long EMD and HYG.