Friday, September 7, 2012
Swap spreads have been among the best leading indicators of the health of the economy that I know of. The swaps market is typically very liquid and populated mostly by large institutional investors, the sort that move $billions with a phone call. They are usually smart and well-informed, at least better-informed than the guy on the street. So when swap spreads change in a big way, it's because big money is sensing a big change in the underlying fundamentals.
The big decline in swap spreads in late 2008 and early 2009 correctly foreshadowed the end of the recession some months later. The big decline in Eurozone swap spreads that we've seen this year is a sign that liquidity has returned, confidence in the banking system has returned, and that the risk of a systemic failure in the Eurozone has all but disappeared. (See my swap spread primer for more background) From that it follows that there is reason to think—even though the PIIGS have not yet implemented necessary fiscal reforms—that we've seen the worst for the Eurozone economy. Things could start improving well before year end at this rate.
The equity market is beginning to figure this out. Since the big PIIGS scare of September 2011, the S&P 500 is up over 30%, and Eurozone equities are up over 25%.
Governments don't fix economies, the private sector does—if given breathing room and time. The way I see it, the Fed and the ECB have supplied sufficient liquidity to restore financial markets to health. Liquidity allows big transactions to occur at lower cost, and it allows the market to resume its search for information (i.e., price discovery). Governments are no longer trying to "stimulate" their economies with debt-financed spending. Keynesian stimulus has been thoroughly debunked, and now it's only a matter of time before more sensible stimulus policies are put in place that could really get economies going. In the meantime, we are seeing the U.S. economy undergoing a very modest "organic" recovery that is being held back by powerful headwinds (e.g., the uncertainties surround the election and the looming fiscal cliff).
Posted by Scott Grannis at 2:58 PM