Friday, September 30, 2011

Swap spread update

Swap spreads continue to be excellent, market-based, forward-looking indicators of financial and economic troubles ahead. The swap market is highly liquid, and spreads are a very good indicator not only of counterparty risk (typically large banks) but also of systemic risk. When swap spreads rise above their "normal" range of 25-35 bps, then that means there are some real problems brewing in the economy.

Today, U.S. 2-yr swap spreads are only 33 bps, and they have been within a normal range throughout the current business cycle expansion. They are telling us that financial markets are healthy and enjoy sufficient liquidity, and this is consistent with an economy that is growing, however slowly. There are no hidden surprises out there just waiting to ambush us. Spreads have picked up a little this year, but that can be traced to worries about the health of European financial markets, where 2-yr swap spreads are almost 100 bps. Europe has a problem—the very real threat of sovereign debt defaults—but we don't have anything like that.

Another market-based indicator of risk is the yield on junk bonds; the higher the yield, the weaker the economy and the higher the risk that leveraged borrowers might default. Junk bond yields now average 8.4%, according to Bloomberg, 30 bps lower than their average since the current recovery began, and only 20 bps higher than their average since the beginning of last year. Junk yields are 210 bps lower today than they were at the onset of the 2008-09 recession.

Taken together, these two indicators are not even close to signaling a double-dip recession.

And did I mention that corporate profits are at all-time nominal, real, and GDP-relative highs? Businesses have fired lots of people and become lean and mean and profitable. Where is the impetus for another round of huge cutbacks of the size necessary to ambush overall growth?


prlondon said...

Interesting that you leave out junk bond spreads/CDS levels/ implied probabilities of default on junk bonds (they are all interrelated). These are getting to post-Lehman levels. If anything, the widening in credit markets is more drastic than in equities. Swap spreads stopped correlating with indicators of financial sector health a few years ago, and are not to be viewed as such.

Benjamin Cole said...

The corporate profits picture is amazing. I wish we could privatize the entire federal government.

In the private sector, they do more with less, every year.

in the federal sector, from Defense to the USDA to the VA to Commerce, they do less with more every year.

Pragmatic Investor said...

I find it amusing that you can claim swap spread to be excellent leading indicator when all your chart shows is 5 years worth of history.

JR said...

If you instead look at the Euro Swap Spread 2yrs, you will see a very different story. Those levels this week touched the same levels as the immediate post-Lehman period in late 2008. Paints a VERY different picture and shows how bad things are in Europe even though there has been no Lehman (yet).

Fullcarry said...

Pragmatic investor,

2007 was the ground zero of swap spreads. They were never wider than at that time. So the past 5 years pretty much capture the range.

Scott Grannis said...

My chart is fully representative of swap spread history, as Fullcarry notes. I did not show junk spreads, because I think they are being unduly influenced by the abnormally low level of Treasury yields, which in turn are being held at very low levels by fears of some disaster in Europe. The typical pattern of rising credit spreads involves rising Treasury yields and a tighter Fed. That is not the case today. That's why I show just junk yields, which have not risen much at all. Junk-rated companies have seen basically no increase in their borrowing costs. So I think credit spreads are sending a confusing signal right now.

Squire said...

I find comfort in the two year swap spread.

But I don't see any reason the economy will grow. The ECRI points to further slowdown.

Pragmatic Investor said...

So having 5 years worth of data is enough to prove something just because it contains the entire history? There has been only one recession period in the past 5 years. What's the statistic significance of one data sample?

Plus, 2yr swap spread may have only been traded for 5 years. But 2 year swap has been traded for much much longer. One with enough interest rate knowledge and a bit of academic rigor could easily calculate swap spread himself.

John said...

These amazing corporate profits amount to crushing debt on the public credit card. Think about it, corporate taxes have been falling for years as a percentage of total revenue.

Payroll taxes have been rising. Jobs have been sent overseas and American middle class earnings have fallen.

The Gini coefficient has rises.

Government has cut taxes for the wealthy and corporations and borrowed like crazy to replace the shortfall.

All the fancy technical charts may reassure some, but in the Land of the Used Car Buyer, we're not impressed.

Three metrics, though imperfect, tell the real story:
1. Inflation (CPI)
2. Real wages for private sector non-managerial workers (80 percent of our total workforce).
3. Unemployment rate.

Those in the top 15-percent think they are immune from the effects of those three indicators. Over the long haul, they're wrong.

"And therefore never send to know for whom the bell tolls; it tolls for thee."

qwe said...

Global PMI's showing economy us weakening
China manufacturing PMI third month below 50