Monday, September 14, 2009

Swap spread update

It's been a while since I have posted charts of swap spreads. I relied heavily on this forward-looking indicator of systemic risk last October and November, when I asserted that they were telling us that the worst had passed and that we should look forward to an improvement in the economy and the markets in the months to come. Swap spreads have done a terrific job over the years of reacting early to emerging systemic problems (note how they rise well in advance of recessions), and reacting early to the unwinding of these systemic problems (note how they fall well in advance of the end of recessions).

Currently, swap spreads are just about where they should be during times of relatively tranquility in the markets and the economy. They tell us that the storm passed many months ago, and that conditions should continue to improve in the months ahead. Swap spreads are good indicators not only of systemic risk, but also of counterparty risk, the market's appetite for risk-taking, and the market's general liquidity. Today they tell us that all of those important things are going to be normalizing in the future. This is undoubtedly one of the reasons that the equity market has been rising since early March, and it ties in well with the message of rising commodity prices. The U.S. economy is getting back on track, despite all the bad policies coming out of Washington these days (e.g., tariffs on Chinese tires, massive deficit spending, promises of higher taxes, increased regulation of healthcare, etc.), and despite all the concerns still out there (e.g., the coming wave of foreclosures, the 10% unemployment rate).

Here is a basic primer on swap spreads that I wrote last May that explains them in greater detail.


alstry said...

Do you think a big part of the SWAP contraction is because companies are refinancing closer in maturities satisfying the SWAPS and extending at much higher rates with new loans?

For example, last week after factoring fees, homebuilder Standard Pacific refinanced 6 3/4 to 7 1/2% notes with 14% notes extended out a few years longer......maybe it is a sign of Obama's inflationary policies down the road?

Bill said...


I know you've addressed this before, but I keep getting emails from commercial real estate experts predicting that CRE will be the next "shoe to drop" when a bunch of these loans come due later this year and next. Folks at pretty well known firms seem to think it's at least a $1 trillion problem that has not been factored into the current market and ignored by most economists. What do you think?

Scott Grannis said...

I think the market has already priced in this coming wave of defaults in commercial real estate. As evidence, you can check the prices of commercial real estate mortgage-backed securities here:

These securities are trading anywhere from 5 cents to 87 cents on the dollar, averaging about 50 cents. This suggests the market is expecting a significant rise in default rates.

Furthermore, people have been wringing their hands over this issue for many months now. It is hardly going to be a surprise when it happens.

Meanwhile, most of the key economic fundamentals continue to improve, so this is going to help mitigate the damage.

Scott Grannis said...

alstry: to the extent that companies are able to extend loan maturities is consistent with relatively low swap spreads. Both are a sign that the market's appetite for risk and assessment of risk has improved dramatically.