Key credit indicators still green

A typical boom-bust cycle starts with the Fed tightening monetary policy, usually in response to rising inflation and/or an economy that seems to be "overheating," or growing too rapidly. Prior to late 2008, when the Fed began its Quantitative Easing, tighter monetary policy worked by draining liquidity (i.e., by making bank reserves scarce and thus restricting banks' ability to create new loans), which in turn led to higher real borrowing costs and a general credit squeeze. Tight credit conditions and rising borrowing costs dealt a one-two punch to leveraged borrowers, and the bond market expressed this by pushing credit spreads higher as default risk rose.

We are now 2 ½ years into a Fed rate-hiking cycle: the Fed started raising short-term rates in late 2015 from a low of 0.25% to now 2.0%. Real yields have risen from -1.5% to now about zero—still very low from an historical perspective. Not surprisingly (since there has effectively been no tightening), there are still no signs of rising systemic risk or deteriorating credit conditions. Credit spreads remain low and liquidity remains abundant. Although the Fed has been draining bank reserves, they are still magnificently abundant, totaling about $1.9 trillion. 

Bottom line: the Fed "tightening" cycle looks very different today than in the past, mainly because bank reserves are still quite plentiful and real borrowing costs are still very low. 

Chart #1

Chart #2

Swap spreads, shown in Chart #1, have traditionally been excellent coincident and leading indicators of economic and financial market health. (See my primer on swap spreads for more background.) Currently, swap spreads are generally low and fully consistent with healthy financial and economic conditions. Low swap spreads are also indicative of plentiful liquidity conditions and healthy risk appetites. Eurozone swap spreads (see Chart #2) are a bit elevated, however, suggesting that conditions in Europe are not as healthy as in the U.S. Not surprisingly, we observe that the Eurozone stock market has been underperforming the U.S. by a widening margin for the past decade. But despite their being elevated, Eurozone swap spreads are not indicating a serious credit squeeze..

Chart #3

Chart #4

Chart #3 shows the spreads on investment grade and high yield (aka "junk") corporate bonds, and Chart #4 shows the difference between these two spreads. All three measures of corporate credit risk are low by historical standards, and they appear to have been improving in recent years.

Chart #5

Chart #5 shows Credit Default Swap spreads for 5-yr investment grade and high-yield corporate bonds. Credit Default Swaps are highly liquid contracts used by institutional investors to hedge generic credit risk. Here too we see that spreads are quite low.

Chart #6

Chart #7

Chart #6 compares the yield on 5-yr A1-rated industrial bonds to the yield on 5-yr Treasury yields. Both have been rising since the Fed started raising rates. Chart #7 compares the spread on 5-yr A1 Industrials to 5-yr swap spreads. Both are relatively low despite the substantial increase in yields. Note how spreads rose in advance of prior recessions, at a time that the Fed was pushing yields higher. This is further confirmation that the Fed has not been tightening. If anything, these two charts suggest we are still in the middle of what could prove to be a very long business cycle expansion.

Chart #8

Chart #8 shows the delinquency rate on all bank loans and leases, as of March, 2018. Here we see still more confirmation that rising yields have not negatively impacted businesses. Delinquency rates have been falling for almost a decade, and continue to do so.

Chart #9

Chart #9 shows the ratio of C&I Loans (Commercial and Industrial Loans, a good proxy for bank loans to small and medium-sized businesses) to nominal GDP. Here we see little if any sign of excess, and little if any indication that businesses are being unusually starved for credit.

Taken together, these key market-based indicators of credit conditions are still flashing "green." There is no sign of rising systemic or credit risk, liquidity conditions are still plentiful, and thus the outlook for the economy is healthy.