Wednesday, November 21, 2012

Financial fundamentals are quite healthy

It's curious, to say the least, that financial market fundamentals should be relatively calm and healthy at a time when the economy faces significant risk in the form of the so-called fiscal cliff. That is not to say that all is well, however, since the consensus of the market looks for years of very slow growth.


This chart of swap spreads is one of my favorite indicators, not only of systemic risk and financial market health (the lower the spread the better), but also of the outlook for the economy. Swap spreads have a record—albeit not a very long record—of anticipating changes in the health of the economy. They rose in advance of the past three recessions, and fell in advance of the past three recoveries. Currently, swap spreads are unusually low, a sign that financial markets enjoy plenty of liquidity and there is little if any fear that conditions in the financial markets or the economy will deteriorate meaningfully in the next 2 years. In short, considering the low level of swap spreads, it would be very surprising to see the economy slip into a recession over the next year.


Bloomberg has developed a "Financial Conditions Index" which includes not only swap spreads but 14 other key indicators of financial market health. Not only has this index improved significantly over the past year, it is now at a relatively high level from an historical perspective. Nothing here would suggest any deterioration in the financial market fundamentals. When financial market fundamentals are as healthy as they are today, that points to a very low probability of any meaningful deterioration in the economy.


Yet despite all the encouraging signs of financial market health, the extremely low level of real yields on TIPS suggests that the market believes that the economy is likely to be relatively stagnant over the next several years. Nominal yields on Treasuries are at rock-bottom lows as well, and both nominal and real yields are consistent with a view that the Fed will keep interest rates near zero for the foreseeable future. That, in turn, will only happen if the economy continues to struggle, and continues to suffer from a significant "output gap."


Ordinarily, the extremely low level of nominal yields that exist today would be a sign of very low inflation or even deflation. Yet as this chart shows, the expected inflation rate for the next 5 years that is embedded in TIPS and Treasury prices is more or less "normal." Expected inflation according to the Treasury market is 2.1% per year for the next 5 years, and 2.9% for the subsequent 5 years, and that is not at all out of the ordinary compared to the past 15 years. So very low real and nominal yields say nothing unusual about inflation; instead they shout out a very dismal outlook for the economy.


Consumer confidence has increased over the past year, and now stands at a post-recession high according to the University of Michigan's survey. While this is encouraging, the level of confidence is still relatively low from an historical perspective, and only slightly better than the levels we saw during the tumultuous years of the early 1980s. As I see it, consumers are saying that although we have pulled back from the abyss, the outlook remains bleak.

Healthy financial fundamentals, but miserable expectations for economic growth: quite an unusual combination that can only mean that the market is braced for a lot of bad news, as I've been arguing for a long time.

15 comments:

Dr William J McKibbin said...

I am excited for Main Street opportunities at this point -- however, I expect the US will go over the "fiscal cliff" in some form, and that the military-industrial complex, medical establishment, and government workers will be confronted with sacrifices for the first time since the economic crisis began in 2008 -- nevertheless, the fiscal cliff is good news for small and medium-cap value stocks -- the deeper the cuts to the military-industrial complex, healthcare sector, and government workers, the better for Main Street and therefore, America!

PS: I realize that I am voicing some wishful thinking in the above -- but my advice remains to buy dividend and rent-earning equities now while you still can -- the fiscal cliff will drive down earnings in the military-industrial complex, healthcare sector, and amongst government workers very quickly, which is fine with me -- I am not invested in those sectors at all...

Dr William J McKibbin said...

PPS: I would not be surprised to hear that 90% of all US troops now stationed overseas will be redeployed back to the US and demobilized before 2016 -- however, I also expect to see sharp increases in border patrol units in the coming years -- finally, law enforcement is likely experience sharp increases in employment in the near future...

Dr William J McKibbin said...

PPPS: The global skills shortage is also gaining traction against the US -- for example, educators holding Master of Science (MS) degrees in STEM subjects (science, technology, engineering, & mathematics) can abandon their low paying jobs in the US (often just above $100,000 annually), and move immediately into education jobs overseas where the pay total pay package for an MS degree holder in a STEM subject often exceeds $250,000 annually -- these jobs are widely from the Middle East for example -- what America will soon be contending with is the reality that only those with non-STEM degrees will be left in the US to teach the workers of tomorrow -- said another way, the US does not offer have much the a STEM educator in terms of remuneration given that everyone in the US education system is paid based on seniority rather than based on STEM skills -- that's good news for those who hold world-class skills in America...

PPPPS: Future looks bright for those with skills -- for Americans looking for viable future careers in STEM subjects, all that's required is effort...

Public Library said...

Japanese 2YR swap spreads are declining (about avg. since '98) and yet they are headed into another recession.

AAA said...

Scott,

Is it possible that the VIX will have a higher average now with all the computer trading?

Benjamin said...

Very interesting post.

BTW, does anybody else wonder if the "fiscal cliff" is a non-threat?

So what if federal outlays shrink--they are only a burden on productive, working and taxpaying citizens.

Do we even need a USDA, HUD or Labor Department anymore?

Could not military outlays be cut in half?

The VA privatized?

The odious "Homeland Security" department eliminated? (Really, would not private airline companies make sure their jets are not hijacked?)

I see the fiscal cliff as a huge opportunity to downsize the federal government.

How is that bad? It will only free up more resources for the private sector, and I count that as good, not bad.

Gloeschi said...

"Bloomberg Financial Conditions Index": same level as in 2007. The rest is history. Please try harder to make the facts fit your narrative. Tx.

Scott Grannis said...

Gloeschi: The Bloomberg Financial Conditions Index started to plunge 6 months before the onset of the recession, and swap spreads started to soar six months prior as well. I fail to see your point.

Scott Grannis said...

Re: the impact of computer trading on the Vix.

Computerized trading can only be successful if it buys low and sells high. Successful computerized trading will thus tend to reduce the volatility of the market by supplying liquidity. Computerized trading that buys high and sells low adds to volatility, but it is also highly likely to extinguish itself as it generates losses.

Put another way: computerized trading that increases market volatility is highly unlikely to be successful or to persist, therefore it is not something to be concerned about.

wallstreet69 said...

2 yr swap spreads are bogus now that governments backstop the creditworthiness of those respective banks. that is whey the spread is approaching zero such that the LIBOR curve trades right atop the sovereign curve.

Scott Grannis said...

You make a good point, but that doesn't totally invalidate the message of swap spreads. When spreads are low, for whatever reason, the market is liquid, and liquid markets are one necessary condition for a healthy economy.

Repeat: Liquid markets are a necessary, but not a sufficient condition for a healthy economy. It would be better if the government were not intervening in financial markets to the extent it currently is. But backstopping the banks at this juncture is arguably better than not doing so.

Dr William J McKibbin said...

The severe austerity that has been imposed along Main Street USA has yet to be corrected (i.e., declining real wages, declining real home values, and a declining employment to population ratio) -- however, both fiscal and monetary policy makers are finally "clued in" on Main Street anger (e.g., the Fed has initiated QE3 in support of Main Street real estate development, and the GOP is in retrenchment from their recent election loss) -- the battle to win back Main Street political support is now in full swing -- for these reason, both big government Democrats and military-industrial Republicans will now have to develop viable strategies that will address the Main Street depression still raging across the US -- for these reasons, I expect the US will go over the fiscal cliff, which is fine with me -- the fiscal cliff losers will be the military-industrial complex, medical establishment, and government workers, who will now be required to make sacrifices for the first time since the economic crisis began in 2008 -- wise investors will seek to get involved in real estate development in order to exploit new capital being introduced by the Fed via purchases of mortgage-backed securities -- I expect originations of new mortgage-backed securities to accelerate over the coming year, and to continue for at least the next 2-3 years -- Main Street USA is being thrown a lifeline, and US investors should take notice or risk missing this timely opportunity...

Dr William J McKibbin said...

This past election revealed something peculiar to me, that is the number of people I know who "bet the farm" on a GOP win in the past election -- I am not sure why anyone would "go for broke" on the results of a presidential election -- prudence argues that one's investments should be configured to make money regardless of whom is in office -- again, I am hearing the stories of so many people who claim they are now ruined because of the election results -- I wonder how that can be...

theyenguy said...

Total Bonds, BND, fell 0.25% this week, commencing the seesaw destruction of fiat wealth on the exhaustion of the world central banks’ monetary authority; with a realization of the extent and intractability of the inability to rectify the Greek debt problem, a political leadership crisis has emerged in Europe; the ECB will emerge as Europe’s sovereign body; with the rise of new regional sovereignty in the Eurozone, the fiat money system is disappearing, and the diktat money system is emerging, where diktat serves as both currency and credit

Dr William J McKibbin said...

@theyenguy, "the ECB will emerge as Europe’s sovereign body" -- I seriously doubt that -- the southern flank of Europe will not surrender sovereignty to the ECB, which stands at the root of the Eurozone's crisis -- ECB arrogance is failing Europe as a continent right before our eyes -- political instability is more likely throughout the southern flank of Europe as the forces for sovereign default arm themselves...

PS: The inability of central bankers to manage the relationship between economics and politics is one of the significant lessons learned from the global economic crisis that began in 2008.