Thursday, May 14, 2009

Almost back to normal

Swap spreads have accurately forecast conditions in the economy and in the financial markets. They started rising in 2007, well before the financial storm of 2008 hit. They peaked in early October '08, months before the bottom in equity prices in early March '09. They have now returned almost to what might be considered normal. Meanwhile, the debate over the current state of the economy rages, with some (including moi) arguing we've seen the worst and the economy is on the mend, and others arguing that the worst is yet to come.

I think this dramatic improvement in swap spreads is really significant. It reflects the return of liquidity to the bond market; the return of confidence in counterparty risk; the return of an appetite for risk; and a significant reduction in uncertainty. The Vix index, a measure of fear and uncertainty in the equity market, is also almost back to normal. These developments are essential in order for the economy to recovery from last year's crisis, since the crisis arose basically from a crisis of confidence in the banking system.

4 comments:

Tom Burger said...

Scott,

There is no question that markets and people are calmer now, but that is due to a few trillion dollars in spending by the Fed and the Treasury to prop up asset prices, manipulate interest rates, and keep the banking industry intact no matter how counterproductive that might be.

The questions in my mind are: what is going to happen when the multi-trillion dollar deficit is ended? Or is the Fed/Treasury proposing that government and Fed balance sheets will just continue to sky rocket indefinitely?

What kind of a recovery is this? Aren't we just buying a few months or years of relative calm at enormous cost? We have not let the markets sort out the various problems. Most of those problems are still going to be there, only in exaggerated form the next time our leaders try to stop the money binge.

Did you enjoy the housing boom and think it represented genuine prosperity? In retrospect, at least, isn't it quite clear that it was a false boom -- something we would have been better off avoiding? If we had only taken a real recession in 2002 we might have enjoyed a real growth period with much more substantial growth in jobs and maybe even real growth in wages.

When the housing boom got going I was afraid it would lead to far worse problems than we had in 2002. Now I am concerned that this even bigger "government finance boom" wil lead to problems that dwarf our problems in 2009. That's the reason for my lack of optimism.

Paul said...

Tom's comment articulated something that has been rolling around in my mind throughout this crisis. I'll be saving money like crazy even if the government ignites another "false boom" because the day of reckoning will be so much worse than if we just take our medicine now. By the same token, if we had taken our medicine in 2002 then the scope of today's crisis would have been smaller.

Bernard said...

Tom and Paul I compeltely agree. I will be saving like crazy and investing in TIPS, commodities, and Non $ assets.

You cannot transfer the defunct leverage of the financial system onto the already leveraged government and expect a better result. The government is even worse at managing their finances than the market participants that failed. Everyone knows that.

This stop is another in the long downward spiral of America. We have now reached the fianl link in the game of hot potato.

The question of when I.O.U.S.A collapses is about all there is left to debate.

ronrasch said...

Is a two year credit swap the difference between short term and two year bonds?