Swap and credit spreads still say no recession

At this point it's almost perceived wisdom that the economy will soon slip into a recession, with the only doubt being the degree of severity. I remain skeptical, however. It's true that the Fed is very tight and the yield curve is very inverted—both being classical precursors to recessions in the past. But there are other precursors to recession that are not present today, namely wide and rising swap and credit spreads. And while some observers note with concern the unprecedented decline in the M2 money supply over the past year, I view it as a welcome return to something more normal—after all, M2 is still significantly higher than its historical trend vs nominal GDP. To be sure, the growth in private sector payrolls has slowed in recent months, and appears likely to slow further (from 4-5% a year ago to now 2%), but it's still far from being in recession territory.

I also think there's a good chance that the market is overlooking the fact that the current round of Fed tightening is unique in one important respect: the Fed is pushing short-term interest rates higher directly, without draining bank reserves (as they always did in the past). That means that this time around there has been no shortage of liquidity in the banking system, and that's a big deal. Liquidity (e.g., ample amounts of cash and an abundance of risk-free, interest-bearing securities like bank reserves and T-bills) is essential to functioning and efficient markets. Efficient markets, in turn, function as "shock absorbers" for all sorts of ups and downs in the economy. Are you comfortable holding certain high-yielding corporate bonds but afraid that all bonds will lose value in a rising-rate environment? Then use the swap market to neutralize the risk of higher rates while still retaining exposure to the companies you like. Swap spreads are pretty low these days, and that means you can easily swap out of the risk you are uncomfortable with. Efficient markets allow people to tailor their risk profile to suit their particular appetite for risk, instead of just bailing out of everything. Liquid and efficient markets are like being in an open-air theater when someone yells "fire!" There's no panic, because there are no crowded doors you have to exit through.

All eyes will be on Wednesday's April CPI release, with most expecting to see no change in the year over year measure (5.0%). I think there's a decent chance of seeing 4.8%, which would also mean that over the past six months, inflation will have been rising at a mere 3.1% annualized rate. If I'm right, it will likely be because the increase in homeowners equivalent rent will be decelerating, as it began to last month. (See this post for details.) An easing of inflation would go a long way to restoring faith in the future, since the market would view the Fed's job as mostly done—with declining short-term interest rates breathing life into most areas of the economy. 

Here are a few charts to illustrate these points:

Chart #1

Chart #2

Chart #1 shows the level of 2-yr swap spreads. In normal times, this spread trades between 15 and 35 bps. Today it was smack in the middle of that range. Thus there is no sign of any unusual stress in the bond market, and to judge by this fact, liquidity is still abundant. This spread has spiked to 60 bps or more in advance of past recession, as Chart #2 shows.

Chart #3

Chart #3 shows the level of Credit Default Swap spreads. This is a highly liquid barometer of the health of corporate profits (tight spreads indicate strong profits, rising spreads indicate deterirorating profits). As with swap spreads, there is no sign of distress here. Indeed, the market seems to have largely brushed off the risk associated with the collapse of Silicon Valley Bank last March. 

Chart #4

Chart #4 is Bloomberg's index of financial conditions. It aggregates all sorts of sensitive, market-driven indicators (see the components listed at the bottom of the chart). Today, financial conditions appear pretty much normal, whereas they reliably decline in advance of recessions.

Finally, my contrarian instincts perk up whenever I hear almost everyone warning about an impending recession.