Monday, November 9, 2009

Credit spread update

I've been chronicling the evolution of swap and credit spreads for over a year now because I think they are key, market-based indicators of financial and economic fundamentals. If I had to choose between knowing what the unemployment was or knowing what the option-adjusted spread on corporate bonds was (see chart above), I wouldn't hesitate to choose spreads. The unemployment rate is flawed because it is impossible for the government to measure accurately (they can't possibly survey a workforce of more than 150 million people, so the government is forced to rely on surveys and guesstimates), and because it is backward looking—people don't get fired or hired until well after the economic fundamentals deteriorate or improve.

Swap and credit spreads, on the other hand, are determined daily by many millions of people around the world who do their part to clear the supply and demand for credit in this massive global economy. No surveys, no guesses: there is real money at stake here, and the market in aggregate has access to information that government bureaucrats can't possibly obtain.

Swap spreads typically lead the way, and they returned to "normal" last summer, as I noted here. The big decline in swap spreads that occurred in November and December of last year was the first serious indicator that the economy was on track for an eventual recovery. Credit spreads take longer to react to changing fundamentals, but as the chart above shows, they too have narrowed significantly since peaking at previously-unimaginable levels last year.

When I look at credit spreads today, I see great optimism in the fact that they have narrowed so dramatically. But if I just look at the level of spreads today and compare that to the history of spreads prior to last year's economic collapse, I see great pessimism. Credit spreads today are at levels that would have been consistent with the onset of recession at any other time in the past. This forms the basis for my statement in an earlier post today that, whereas the market was braced for a massive depression earlier this year, it is now braced for a simple recession. I see no signs of unfounded optimism in this market, since there are still plenty of signs of deep fear, uncertainty, and pessimism: implied volatility, credit spreads, and consumer confidence are still well above normal levels, and Treasury yields are well below normal levels. The market, like the economy, is still recovering from a massive blow.

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