Tuesday, July 28, 2015

Credit spread update

As I mentioned last week, lower oil prices (and falling commodity prices) have given the markets a case of the jitters. Default risk in the high-yield energy sector is up significantly, and this has sparked fears of a credit default contagion. It doesn't help that Chinese stock prices are extremely volatile (and currently falling) and that the Chinese economic powerhouse has slowed down measurably. But looking deeper into the numbers, so far there is no sign of any contagion; markets are still very liquid and systemic risk is low. Markets are very good at weathering storms as long as they are liquid. It's therefore likely that this storm will pass, as many others have in recent years.

This chart shows the spread on high-yield energy bonds, which has spiked of late to a new post-recession high in response to the renewed decline in oil prices.

The deterioration in the energy sector has spread somewhat to other sectors as well. Investment grade and high-yield spreads in general are up, but only moderately. The damage is more or less limited to the energy sector.

I've long touted the ability of 2-yr swap spreads to be excellent leading indicators, because of their ability to give advance warning of big problems in the economy. The chart above adds to the story, since it shows that swap spreads have indeed been leading indicators of high-yield spreads, and sometimes by a considerable amount of time. Today, swap spreads are trading well within the range of what might be considered normal: 20-30 bps. This tells us that financial markets are healthy, and that in turn is a good sign that there is no fundamental deterioration going on in the broad economy. It's an energy "crisis" of sorts that is bad for producers and associated industries, but good for just about everyone else. It's not the end of the world.

It's hard to put complete faith in the economic statistics coming out of China, but according to the government, the economy is growing at about 6-7% per year. That's way down from the heady 10% growth rates which prevailed in the mid-2000s, but it's still pretty impressive—at least twice the growth rate of the most energetic developed economies. However, one number the government can't easily fake is the central bank's holdings of foreign exchange reserves, shown in the above chart. Forex reserves have been in a $3.5 - 4 trillion range for the past several years (most of it invested in U.S. Treasuries). Over the past year China's forex reserves have fallen from $4 trillion to $3.7 trillion. Meanwhile, the yuan has been relatively stable against the dollar for the past 4-5 years. What this means is that capital is no longer flooding into the Chinese economy. The rising tide of reserves—which lasted some 20 years—has reversed, with minor capital outflows of late. That squares with China's slower growth rate. The boom times are over; now, instead of extremely fast growth, China is experiencing simply fast growth. That growth is being financed organically, and China's growing and rapidly aging population is beginning to invest overseas, at it should. None of this is troubling, but it is a big change—a great inflection point—that will take some getting used to.

UPDATE: A decline in China's forex reserves means that the central bank is selling some of its forex reserves in order to keep the yuan/dollar exchange rate stable. That in turn means China has been (and most likely will be) selling Treasuries. But what happens to the dollar proceeds of those sales? The dollars raised by the central bank's sale of Treasuries must, at the end of the day, be spent on something in the U.S., such as equities, bank savings accounts, real estate, tourism, movies, and assorted goodies. In other words, capital moving out of China means increased purchases of U.S. goods, services, and equities.


Benjamin Cole said...

China is a cipher. The People's Bank of China has lowered its inflation targets and is undershooting Anyway. They have PPI down four years running.
Yet even at 7% growth they will double in 10 years.
I wonder if China is too big to be run well under their system especially but maybe any system.

Anonymous said...

Re China Update. I can’t help wondering who is buying the treasuries China is selling. It has to be investors who think treasuries will go higher and interest rates lower and they are picking up bonds at a good price. I am sure those investors believe China can be trusted to not rock the boat by selling too much at a time.

Is defending the USD/RMB exchange rate tightening when the USD is rising? The rest of the world will buy less of China’s exports with their weaker currencies. Thus slower growth just as if they raised interest rates.

Here is the FRED chart for the 2 year swap rate for those that don't have a Bloomberg terminal.

DSWP2 or just put in 2 year and it will be offered.

NormanB said...

RE: Where the money from China's selling of Treasuries will go.

Finally, someone writes about the closed system of assets as it is more like transferring. You sell something, you have to buy something else. Further, if someone is selling Treasuries someone else is buying Treasuries.


Anonymous said...

China sells Treasuries in exchange for USD. They then exchange the USD for RMB which pushes down the price of the dollar they sold and ups the price of the yuan they bought which is their objective. Now China has yuan instead of Treasuries. If they buy US goods, services, real estate, and businesses, or Treasuries for that matter, they have to sell the yuan and buy dollars defeating their original objective.

Are they not stuck with yuan? If so, serves them right for all those years of financing the US deficit in order to keep their currency lower. If they couldn't place the USD, they would have had too much USD with no place to put it. Then they would have had to revalue the yuan to slow exports to slow accumulation of dollars. At least I think so.

If this imbalance has hurt US manufacturing over the years, perhaps the readjustment will help US manufacturing now.

zumbador said...

Thanks for the excellent data on credit spreads, the reference to the energy area and the very good bullet points on China.
I greatly appreciate ALL the info and commentary you provide.

Hans said...

Ben Jamin, Red China's growth will be much lower than what
pundits are suggesting..I suspect rate of 4 to 6% annually
and further declining a decade from now.

It is silly to argue that the Communists will be honest in
their official pronouncements.

"That in turn means China has been (and most likely will be) selling Treasuries."

Actually they have been selling US Bonds over the past 12+ months..Mainland China
is no longer the number one holder of US debt..That title has reverted back to

Benjamin Cole said...

Hans-- I have nothing good to say about Chinese authorities, who abuse human, civil and commercial rights at will.
The country may in fact melt down.

That said, if they have a growth-oriented central bank which prints money which is accepted domestically and globally, they may be able to overcome their problems.

The worst thing for China to do would be to copy Japan and have a central bank that for 20 years brings on deflation.

Tight money and structural impediments are a bad combination.