Friday, March 11, 2016

The deflation/recession threat recedes

Exactly one month ago, many thought the world was about to tumble into a deflationary abyss.

Oil prices had collapsed to $26/bbl, high-yield spreads had soared to almost 900 bps, HY energy spreads were within inches of hitting 2000 bps, 5-yr inflation expectations had fallen to 1.0%, the Vix index was approaching 30, 10-yr Treasury yields had plunged to 1.66%, and the S&P 500 was down 15% from its all-time high.

What a difference a month can make. Today, all of these key indicators have reversed significantly. Oil is up 45% and approaching $40/bbl, high-yield spreads are down and approaching 650 bps, 5-yr inflation expectations are back up to 1.5%, the Vix index is down to 17, 10-yr Treasury yields are just shy of 2%, and the S&P 500 is only down 5% from its all-time high.

I note that one key indicator hasn't changed at all in the past month: 2-yr swap spreads remain very low (5-6 bps). As I've said numerous times in recent years, swap spreads are excellent coincident and leading indicators of financial market health. Very low swap spreads tell us that liquidity is abundant and systemic risk is low. Low swap spreads mean the underlying mechanisms of the financial markets are working just fine, allowing the market to spread risk from those who cannot bear it to those who can. Liquid, functioning financial markets are key to a healthy economy, just as are free-market prices. Price signals (e.g., cheap oil) have persuaded producers to bring their production more in line with demand. Markets have short-circuited a deflationary collapse.

We're fortunate that governments haven't stepped in to try and "fix" things that weren't broken to begin with (unlike what happened in the latter half of 2008).

I also note that one month ago there were signs that indicated we weren't headed for the end of the world as we know it. Industrial commodity prices were beginning to turn up. The CRB Metals index is now almost 20% above its January lows (see chart above).

It's tempting to say that yesterday's ECB announcement (i.e., more QE) made all the difference, but I'm not convinced. The turn for the better has been underway for the past month, and maybe the ECB announcement provided an additional nudge. For what it's worth, here is a recap of what's been going on in chart form:

Above: oil prices have rebounded sharply from their Feb. 11 lows. The fact that the active rig count in the U.S. has collapsed by 75% in the past 15 months is an excellent sign that producers have cut back production. Meanwhile, oil demand is up around the world.

High-yield Credit Default Swap spreads have tumbled, as higher commodity prices reduce the risk of corporate debt defaults.

The 5-yr expected rate of inflation embedded in the prices of 5-yr TIPS and 5-yr Treasuries has surged from 1.0% a month ago to almost 1.5% today, as higher oil prices mean that the headline CPI is likely to be much higher than the market feared. 

One more installment in the Walls of Worry chart that I've been featuring periodically. Fears are receding, and the prices of risk assets are rising. It's the same pattern we've seen repeated numerous times in recent years.

Good as all this has been, we're not out of the woods yet. As the chart above shows, the prices of gold and 5-yr TIPS are still relatively high, which means the market is still willing to pay up for the protection these unique assets offer. Gold rose to almost $1250/oz on Feb. 11, and today it is a bit higher at $1260. The real yield on 5-yr TIPS fell to 0.1% on Feb. 11, and today they are a bit lower still (the chart uses the inverse of real yields as a proxy for TIPS prices). You might not see it in the headlines, but elevated gold and TIPS prices tell us that the market is worried about the future direction of inflation being up instead of down. With a strong bounce in commodity markets occurring at the same time that major central banks have their policy pedals to the metal, it's not impossible that we could see inflation rising above target before too long.


NormanB said...

Negative sovereign interest rates all over the world doesn't make me confident in a prediction of an inflationary environment any place except Russia and Venezuela.

Benjamin Cole said...

Great post.

NormanB makes good point. Investors in large parts of the developed world are willing to pay for the privilege of financing government operations. And of course Japan is in deflation even yet and the PPI in China has been dropping for 49 months straight. So, globally, deflation is in fact in the picture in the present.

Gold is up this year. Central banks and Asian jewelry buyers are the market. I find astrology and gold prices equally informative.

This has been a strange year in that the world seems to be celebrating higher oil prices.

William McKibbin said...

The good news is that stocks are up -- it's magic!

William McKibbin said...

PS: I don't believe in magic -- beware of the sucker rally now underway -- what we are seeing in the stock market is not real -- far from it -- keep a sharp eye on earnings...

Francisco Javier Fernández Viana said...

Thank you one thousand times, Mr. Grannis, for this insightful information about the markets.