Monday, November 2, 2015

Swap spread stabilizer at work

Starting 11 weeks ago,  the market suffered a collapse that erased 11% of the value of the S&P 500 in a mere 6 days. Today, it fully recovered from that collapse, and is up 2.2% for the year to date. The apparent cause of the collapse? Fears that the Chinese economy was in free-fall and sharply lower oil prices would produce a wave of defaults starting in the energy sector and spreading to others. Investors extrapolated these fears and began worrying about another global contagion that could rival the near-collapse of the financial markets in 2008. Yet all that has happened between then and now is that a slower-growing China and lower oil prices were not, in fact, contagious. China is not in free-fall, and oil prices have stabilized around $45. Economic life goes on, unperturbed by the problems in China and the oil patch.

Equities have rallied because the future did not turn out to be as bad as investors had feared. This has been the meme of the entire recovery which began in 2009. Equities haven't rallied because things have improved; this is still the weakest recovery ever, and there are no convincing signs to suggest the recovery is going to get meaningfully stronger. No, equities have rallied because there has not been a meaningful deterioration in the economic fundamentals—a deterioration significant enough to justify sitting in zero-yielding cash while foregoing the much higher yields on riskier investments.

As the chart above shows, there has been a very strong inverse correlation between equity prices and the level of fear, uncertainty, and doubt prevalent in the market (using the ratio of the VIX index to the 10-yr Treasury yield as a proxy for FUD). As fears have declined over the past 11 weeks, equity prices have risen, in virtual lockstep.

The ISM October manufacturing survey wasn't particularly impressive. In fact, it suggests that economic growth in the current quarter will remain disappointingly slow.

Fortunately, manufacturing conditions in the Eurozone have firmed marginally over the course of the year. Still, there's nothing here to get excited about, except to the degree to which these surveys rule out another recession.

Meanwhile, September construction spending showed continued strong gains. Total construction spending is up 14% over the past year. led by a 17% advance in residential construction.

It's a hot-and-cold economy, with some sectors (e.g., construction) doing very well while others (e.g., energy production) are doing poorly. This mixed bag of indicators has been highly conducive to FUD.

What was the secret to understanding that the world was not on the verge of another recession? Swap spreads, which have been and continue to be very low. As I've stressed for months, very low swap spreads are an excellent indicator which suggests that systemic risk is low and financial markets are very liquid, and therefore the economic outlook is more likely to improve than not. Liquid markets and low systemic risk allowed market forces to sort out the difficulties presented by a slower-growing China and a lower oil prices. Financial markets have in effect been a very efficient stabilizer which has insulated the global economy from the tremors in the Chinese market and in the oil patch. This stabilizer functions by allowing large institutional investors to efficiently and effectively transfer risk via swap agreements.

Swap spreads continue to point to improving conditions ahead.


Benjamin Cole said...

Excellent insights in swap spreads.

BTW, as Scott Grannis shows, this has been a weak recovery---but it has been record gangbusters in one regard: corporate profits.

US corporations are reporting the best, highest corporate profits, relatively and absolutely, by huge margins in recent years.

These are the good ol' days for corporate profits.

steve said...

like your chart of HY vs swaps. judging by it and given that HY is yielding over 400 bps vs 10 year and that US economy looks steady, HY a bargain.

Scott Grannis said...

steve: don't forget that it's the HY energy sector which is driving a lot of the spread widening in HY bonds. Still, I would agree that HY in general looks attractive.

marcusbalbus said...

price gains are not yield. you should be more careful in your cheerleading. and there are many who disagree with you on what swap spread narrowing mean. you clearly suffer from the post hoc ergo propter hoc logical fallacy.

Frozen in the North said...


That's what she said!

Seriously I get worried when Scott sounds so "calm" where's my favorite of the doom and gloom brigade need Scott at full speed. BTW I agree, the market has been one huge wet blanket. My worry is that there's little juice left in earnings. Look at Apple -- is it reasonable to thing that they will continue to earn 40% margin, when everyone else in the phone sector is breaking even? I mean really

Matthew Grech said...

For years now, I've thought that corporate margins will stay higher for longer. It's true that they are historically (extremely) high. But it's also true that just about every industry has become significantly more oligarchical, dominated by a fewer number of players. It's also true that overall capital expenditures have been very low relative to corporate profits and new business start-ups are glaringly lacking. Finally, the regulatory climate leaves little doubt about the benefits that are accruing to corporate incumbents. So...

...It looks like profits and margins stay higher than people think. This combined with the (probable) reality that rates stay low for longer than people think means that stock valuations could go higher. And it's possible they could go significantly higher. Still, I can't help but think that the longer term economic vitality of America is dimming in a big way. Competition and new company formation are on the wane and for very fundamental reasons. The regulatory moves have been abysmal and are not easily reversible. Also, I estimate that at least 10% of the potential work force, and maybe as high as 20%, is unemployable in today's economy.

But looking purely at profits, it's actually a pretty attractive picture.

Johnny Bee Dawg said...


Great call on the market last month. Dow up 9%. Best month for stocks in 4 YEARS!
You hit a home run, buddy!

marcusbalbus said...

Johhny lard dog: stick to frightening little children and goats. you are much better at it.

Galactic said...

As an added course to the buffet of great information on this blog-- I saw this (incredibly nerdy) commentary on swap spreads. I'll need to read this a few time to absorb it...

Scott Grannis said...

Galactic: thanks for contributing that link. I think what Anonymous says is consistent with what I've been saying. When swap spreads are very low or even negative, it means that there are more people willing to take on risk (i.e., being "receivers") than there are who want to reduce risk (i.e., the payers). Accounting and regulatory issues are not optimal, and that appears to be aggravating the situation to some extent. But it is still the case that liquidity is abundant, and it is very easy for those who want to offload risk to do so.