Monday, August 7, 2017

Credit spreads tell a bullish story

Credit spreads—the extra amount of yield that investors demand to hold debt that is riskier than Treasuries—are uniformly low these days. That tells us that liquidity in the bond market is abundant, systemic risk is low, and the outlook for corporate profits and the economy is healthy. '

Swap spreads (see a short primer on swap spreads here) are arguably the bedrock and most important of all credit spreads. "Normal" spreads on 2-yr contracts are roughly 20-40 bps. At today's 25 bps, 2-yr swap spreads are perfectly normal. This tells us that bond market liquidity is relatively abundant. Fed tightening has not created a shortage of money, as it usually does in advance of recessions. It also tells us that systemic risk is perceived to be low. As the chart above suggests, swap spreads tend to be good predictors of conditions in the broader economy; spreads tend to rise in advance of recessions and decline in advance of recoveries.

As the chart above shows, swap spreads in the Eurozone are elevated. Conditions are not as healthy there as they are here. Eurozone spreads are not dangerously high, but they do reflect some systemic risk, which is likely related to the perception that the Eurozone still faces existential risks from countries thinking about "exiting" the Eurozone. Given the higher spreads in the Eurozone, it is not surprising that Eurozone GDP growth has been lagging that of the US for a number of years. Riskier markets tend to receive less investment—and consequently less growth—than less risky markets.

The chart above shows credit spreads as derived from the universe of bonds issued by US corporations: $6.3 trillion of investment grade bonds, and $1.3 trillion of high-yield (junk) bonds. Both spreads are relatively low, as you would expect them to be in a healthy, growing economy. They are not at record lows, but they are low enough to be impressive.

The chart above compares 2-yr swap spreads to high-yield corporate spreads. Here we see further evidence of how swap spreads tend to be good predictors of the health of the economy (HY spreads are particularly sensitive to the underlying health of the economy).

The chart above shows 5-yr Credit Default Swap spreads. CDS spreads are derived from generic contracts representing hundreds of large, liquid corporate bonds, so they are reliably good proxies for overall credit risk. Their message is the same as other credit spreads: conditions are normal, and thus the outlook for the economy and corporate profits is healthy.


PerformanceSpeaksForItself said...

Hi Scott, thanks for the post, informative as usual. Any thoughts on short Vix ETFs as a potential future tinderbox?

Scott Grannis said...

The Vix has been very low for the most part ever since the November election. Obviously it is not going to be that low forever. At some point something will happen that will disrupt the relative calm that pervades today's markets. But the problem is that we have no idea when that will happen. Buying options on equities would seem to be a reasonable strategy, since a very low Vix means that the price of options is very low. But again, volatility might remain low for a long time, in which case your options are going to expire worthless. I'm not one who tries to play the timing game.

Alain said...

Aewsome scott. Thank you for doing this posts.

These are my favorite graphs.

Al from Canada.

AmericanFool said...

Nice perspective, thanks Scott. I have to be careful about confirmation bias when reading your posts - virtually everything I read here mimics my own general thoughts, but of course with far more data and discussion behind it all.

Andrew Ross said...


You stated that credit spreads (including junk), while low are not at record lows.
From looking over the charts, it appears that record lows were established in 2007 and the 97/98 time periods.

2007 impresses me as a time of economic distortions, that were eventually corrected.
97/98, on the other hand was a very different time period than 2007.

Curious to know if you could share some insight into these previous periods of record lows.
What was it about those periods that lead to such low spreads? (my thoughts are irrational euphoria)

Current High Yield spreads are about the same as 2014. Please correct me if I'm wrong, but was it basically concerns about the Chinese economy that precipitated the rise in spreads leading to the spike in 2016?

Thank-you again for such great posts!

Scott Grannis said...

Andrew: Thanks for your question, which merits a response.

1997 and 2007 shared a few things in common: the economy was quite strong (real growth of around 3.5-4.5%), the Fed was tight (real Fed funds rate was around 3%), yields were relatively high (10-yr Treasury reached 7% in '97 and 5% in '07) and credit spreads were historically low. Spreads were low because the economy was quite healthy and expected to stay that way. Markets were subsequently blindsided by recessions.

Today the economy is muddling along at 2%, the Fed is easy (real Fed funds rate a bit less than zero), yields are historically low, and credit spreads are relatively low. Today, in other words, is quite different in important ways from the prior two periods of low credit spreads. Ed Yardeni says spreads are low today not because the economy is strong but because slow growth, subdued inflation, and a non-threatening Fed increase the odds of a very long expansion. That resonates with me; the market is not exuberant, but rather comforted by the perception that neither a recession nor a boom are likely for the foreseeable future.

Alan Greenspan first hinted at irrational exuberance in late 2006, but I don't recall the market being frothy (PE ratios were somewhat above average in '97 and merely average in '07). True exuberance didn't show up until late 1999, by which time credit spreads had already spiked higher and PE ratios were on the moon.

The spike in spreads in 2016 was driven by collapsing oil prices and the expectation that oil producers were going to go belly up, followed by Brexit fears. The China blowup (fears that the economy was going to collapse) happened in the summer of 2015.

hmp49 said...

"Fed tightening has not created a shortage of money, as it usually does in advance of recessions."

Bank lending has been low as demand has been low, and banks were using their "free money" to invest in Treasuries.

The Fed has not started to liquidate their $4.5 trillion accumulated during QE. When that happens, it hits the fan.