Friday, September 23, 2011

Corporate bond valuation update

This chart shows spreads on 5-yr credit default swaps, for investment grade and high yield corporate bonds. Spreads have surged since July, and are now back to levels that preceded and foreshadowed the onset of the worst of the Great Recession. Is this a sure sign that we are on the cusp of another recession? As much as I think spreads are excellent and forward-looking indicators of economic and financial market fundamentals, I don't think this chart shows the whole story.

This second chart compares 2-yr swap spreads to junk bond yields. Swap spreads are excellent and forward-looking indicators of systemic risk; today they are in the upper range of the levels (15-35 bps) that typically prevail when the economy is navigating relatively stable seas. Swaps did an excellent job of predicting the collapse of the junk bond market in 2008, and an excellent job of leading the huge rally that began in late 2008 and continued through last year. Today, swap spreads are signaling only mild upper pressure on junk yields—nothing to get very excited about.

So why are spreads on corporate debt (top chart) so high? It's mainly because the yields on Treasury debt are extraordinarily, incredibly low. The European sovereign debt crisis has created gigantic demand for Treasury debt, greatly depressing yields in the process. The big widening of corporate debt spreads is only partly due to a deterioration in the prospects for U.S. companies, and mostly due to the desperation that is gripping European investors.


Benjamin Cole said...

Commodities Fall to Nine-Month Low
By Sharon Lindores - Sep 23, 2011 6:45 AM PT

Commodities fell to a nine-month low as silver, copper and nickel tumbled on deepening concern that policy makers are running out of tools to avert another global recession, hurting demand for metals, fuel and food. Gold fell below $1,700 an ounce in New York.
The Standard & Poor’s GSCI Index of 24 commodities fell as much as 2.2 percent, the most since Dec. 2, and was down 0.8 percent at 2:40 p.m. in London. The index is down 7.8 percent this week, the most since May 6. Silver slumped 10 percent, copper was down 2.7 percent and nickel dropped 3.1 percent.

Some people cite commodities as inflation indicators. I think globalized commodities are becoming less and less valuable as indicators for USA inflation or economic activity. But if they are, they are sinking.

David Waltz said...

That makes sense - banker's always tell us that bond rates are "sticky" once you get too low on the benchmarks.

Benjamin Cole said...

Cleveland Fed Estimates of Inflation Expectations

News Release: September 16, 2011
The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.37 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

The Cleveland Fed’s estimate of inflation expectations is based on a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the "break-even" rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates. The Cleveland Fed model can produce estimates for many time horizons, and it isolates not only inflation expectations, but several other interesting variables, such as the real interest rate and the inflation risk premium. For more detail, see the links in the See Also box at right.

Estimates are updated once a month, on the release date of the CPI.The methodology used to generate the estimates was changed slightly starting June 15, 2011, and it is documented in this working paper.


It would the hysteria about inflation was badly misplaced.

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Benjamin Cole said...

Greg Mankiw predicted a 20 percent dump on the Dow when QE2 ended. I guess he was right.

McKibbinUSA said...

What's becoming clear is that monetary and fiscal policy are willing to trade deflation in real estate and commodities, for greater economic stability globally -- the various manipulations and interventions by global economic authorities are creating economic data that is incongruent with global realities -- said another way, beware of the econometrics, at least in the near-term -- something is very wrong right now...

TradingStrategyLetter - Weekly Summary said...

What is clear to me is that central banking types are softening up markets for a whole snootful of inflation. No practical solutions are being put forward on purpose. The great thinking liberal minds which got us in this mess are - for whatever reason - still charged with solving this disator. These Keynes disciples know nothing else. Strap your self in for the ride of a lifetime. This baby is gonna blow up like you won't believe!