Reading the market tea leaves: swap and credit spreads still relatively benign

Swap spreads are excellent coincident and forward-looking indicators of the general health of the financial markets and the economy. (See my short primer on the subject here.) They are therefore one of the most important indicators for investors to follow. The news of late has been mixed to negative, with a modest pickup in growth in the U.S. economy overshadowed by increased tensions in the mideast, weak economic growth in Europe, the return of the "Grexit" problem (the potential for a default on the part of the Greek government, or a decision to leave the Euro), the collapse of oil prices (which has threatened the economic viability of Russia, Venezuela, and heavily indebted oil companies), and the ongoing slowdown in China (which nevertheless continues to grow at a pace that would be the envy of every other nation on the planet). On net, markets have gotten worried, as I've noted in many numerous posts of the "climbing walls of worry" variety.

To judge by the level of swap spreads, however, the problems that beset many parts of the world are not particularly worrisome. Swap spreads remain relatively low, with the bulk of the widening confined to the energy sector. Even there, we find that spreads have narrowed in recent weeks from their initial panic highs. The following charts tell the story:

The chart above emphasizes the role of Quantitative Easing in both the U.S. and Europe. QE's major impact was directed to the financial markets (not to the economy, as so many assume), since QE basically involved the provision of liquidity to the banking system: the Fed purchased notes and bonds and paid for them with the issuance of bank reserves, which are functionally equivalent to T-bills. 2-yr swap spreads. Banks needed liquidity and the world's investors were desperate for safe asets—both were in very short supply—and QE addressed that problem. But QE1 and QE2 were both ended prematurely, as evidence by the widening of swap spreads that occurred around the time of their demise. QE3, on the other hand, ended at the right time. Swap spreads have only increased marginally since the end of QE3, mainly because of the concerns surrounding Greece, falling oil prices, etc., that I mentioned above. The current level of swap spreads is fully consistent with "normal" financial market conditions.

The chart above shows 2-yr swap spreads in an historical context. Here again we see that the current level of spreads is relatively benign. The world's investors may think there is a lot of risk out there, but swap spreads tells us that the financial system is able to support the risk. Markets can manage risk very efficiently if the government refrains from intervening.

The biggest source of risk these days, arguably, is the stress that many oil producers are feeling as the result of the almost 50% decline in petroleum prices since last summer. Spreads on high-yield, energy-related debt spiked several weeks ago, but have since subsided somewhat. Oil prices have stopped declining, and the market has had a chance to better assess the risks involved. The oil industry is facing a big problem, but at this point it does not look like it will intensify or prove contagious to the rest of the world.

The chart above shows the average level of credit spreads for investment grade and high yield debt. Spreads are up from their lows, but they are still quite low from an historical perspective.

On balance, therefore, swap and credit spreads in general are telling us that the likelihood of a major economic or financial market collapse is very low. We are not on the cusp of another recession or another Great Recession. We're more likely in the midst of the sort of one of the run-of-the-mill problems that beset markets from time to time and that are eventually resolved without serious consequences.