Monday, September 28, 2015

Walls of worry update

The inverse correlation between the market's level of fear, doubt and uncertainty as proxied by the ratio of the Vix index to the 10-yr Treasury yield) remains strong, as the chart above shows.

The list of worries is long: China, commodities, oil prices, energy sector debt, emerging markets (especially Brazil), regulatory burdens, high marginal tax rates, and more recently, healthcare stocks that face the threat of politicians who want to control the prices of certain drugs.

And it is still the case that, despite all these concerns and the rising level of corporate credit spreads, 2-yr swap spreads are unusually low. Swap spreads stand out in a field of nerves, because at current level they signal that systemic risk is virtually nonexistent, financial market liquidity conditions are very healthy, and the banking sector is strong (as well it should be, with trillions of dollars of excess reserves).

It's worth repeating that every recession in the past 60 years has been preceded by a severe tightening of monetary policy, which can be seen in a strong and rising dollar, high real yields, a flat to inverted yield curve, and rising credit spreads. Moreover, the past three recessions have been preceded by high and rising swap spreads (the swap market wasn't very active prior to that). Of all those preconditions, only  rising credit spreads can be found today, but as the chart above shows, they are not critically high. Without the confirmation of rising swap spreads, it looks like the problems of the HY debt sector—although serious, especially for the energy and commodity sectors—are not highly contagious.


marcusbalbus said...


Johnny Bee Dawg said...

I think it's interesting that the last 3 major market declines this month coincided with the release of policy statements from leading candidates. There was a 400 point reversal down as Jeb Bush announced his economic plan to punish the wealthy with extra taxes on Sept 9. The Biotech and Drug sectors crashed instantly after Hillary's famous Tweet about capping drug prices and profits. Today's 300 point decline came as Trump formally announced his plan to place extra taxes on the wealthy, singling out Hedge Fund managers in particular.

None of these politicians have learned a damn thing from the effects of 8 years of socialist rants from our current Economic Wet-Blanket -In-Chief. His anti-American rhetoric and threats of confiscation and redistribution ushered in the worst post-election market performance in US history. Barack's later inauguration brought us the worst January market performance in US history, followed by the 2nd worst February market performance in US history.

Obama was and is not as popular as proclaimed. His first election was no landslide in the popular vote. He is the first US President in history to ever win a second term with less votes than He got in His first term. Despite His poor record, and fleeting popularity, all three of these leading candidates decided to follow His lead by ginning up more class warfare, decisive rhetoric, and redistributive if that would remove this wet blanket of economic malaise and risk aversion.

The market is not crashing, but it's definitely repricing in the realization that there is nobody coming to save us. The chances that bad DC policy will be reformed anytime soon are declining rapidly. Risk aversion continues as hope of reform declines.

Obama meets unsupervised with Pope, Xi Jinping, The UN, and Putin all in the same week!! No wonder stocks are down.
Damn. Just damn.

William said...

Scott Grannis wrote: "It's worth repeating that every recession in the past 60 years has been preceded by a severe tightening of monetary policy, which can be seen in a strong and rising dollar, high real yields, a flat to inverted yield curve, and rising credit spreads."

But, Scott, your fundamental fallacy is not to recognize that since 2008, the US and Global economies are in a different era: the zero interest rate, QE era for which there is no historical experience. Plus the obvious facts that each recent decade has had slower GDP growth than the preceding one. This in spite of the the Cheney / Bush era tax cuts, loose regulations, ect. - all the things which you advocate as solutions for our present slow GDP growth.

The simple observable economic facts are that working age populations growth globally has slowed due to the aging of developed nations populations; and productivity is extremely slow averaging 0.5% per annum the past 3 years.

This time the US and Global economies are in an unchartered era which has yielded slower and slower global growth each year.

Personally, I believe that - at least in the US - the borrowing binge associated with the housing bubble (home equity loans, etc.) brought forward a lot of economic activity which yielded higher GDP growth in the bubble years. This has resulted in slower, subpar GDP growth in recent years. Another way of looking at the same slow growth is that the acquired debt by governments, corporations and individuals over the past two to three decades - having first stimulated "growth" - now is a burden which is more difficult to fund given the recent slow GDP growth AND LOW INFLATION.

Thank you, Scott, for your thorough analysis. Best regards,,,William

honestcreditguy said...

honestcreditguy said...
Lows and highs are often re-tested, most likely we will retest the August lows over the next 10 days....Markets should be worried. China is imploding..much more than we know...

Walls of worries sometimes do tumble down....

September 22, 2015 at 8:34 PM

Roy said...


Thank you for another interesting article.

1. "2-yr swap spreads are unusually low"

Why, in your opinion, are they "unusually" low? Could it be due to some technical reason (as in LIBOR convergence, duration etc.)?

2. "only rising credit spreads can be found today, but as the chart above shows, they are not critically high"

At what number would you start to be concerned? They sure look like they are going up higher fast, but maybe it's my brain defecting patterns where they do not exist.


Roy said...

Here's a recent bloomberg article on the swap spreads.

"It's All `Perverted' Now as U.S. Swap Spreads Tumble Below Zero"

Hans said...

"As we enter into 2015, analyst calls for a continued "bull market" advance have never been louder. There have been a litany of articles written recently discussing how the stock market is set for a continued bull rally. The are some primary points that are common threads among each of these articles which are: 1) interest rates are low, 2) corporate profitability is high, and; 3) the Fed's monetary programs continue to put a floor under stocks. The problem is that while I do not disagree with any of those points - they are all artificially influenced by outside factors. Interest rates are low because of the Federal Reserve's actions, and corporate profitability is high due to accounting rule changes following the financial crisis. Lastly, the Fed's liquidity program artificially inflated stock prices.

While the media continues to pound the table with all of the bullish arguments that should continue to drive the current advance in the markets, it is only prudent to at least attempt an understanding of the counter arguments. The "risk" to investors is not a continued rise in the financial markets, but the eventual reversion that will occur. Like Wyle E. Coyote, since most individuals only consider the "bull case," as it creates a confirmation bias to support their "greed factor", they never see the "cliff" until it is far to late."

As I have stated before, there is nothing natural about this "recovery" nor
the stock market advancement (including the bond market)..

Furthermore, the S&P500 has grown by 3 1/2 times in five years!! All investors should
take profits and go cash, as this trend can not and will not be sustained.

The individual investor has the advantage over the index funds; mutual and hedge funds
which general can not go all cash.

The up side offers little in the form of returns..Those with a long time horizon, should
wait for the next bear market (recession) and go from 110% cash position to 100%
fully invested.

xr-3609 said...

Scott:"Swap spreads stand out in a field of nerves, because at current level they signal that systemic risk is virtually nonexistent"

Jeffery Snider
believes: "In what might be the most conclusive indication of illiquidity in the entire spectrum of them, and the most troubling, the compression in swap spreads could not be more clear in terms of interpretation at the 2s"

Scott: Are these two views are diametrically opposed as they appear to be? Is there a technical SWAPs market explanation that can explain both views?

Johnny Bee Dawg said...

You think the Fed controls interest rates? You sure about that?

What accounting rule changes occurred which are allowing corporations to state extra profits?

In my opinion, there was nothing "natural" about the 2008 decline, and stocks are just getting back to where they should have been.

Unknown said...

Scott. Remembering the end of the Bush administration, has me thinking how bad this next year could be. How many oil drillers (shale) workers will be let go this year? I don't know the answer but would appericate anyone else who does. Europe seems to be looking for a New reason to collapse.

Benjamin Cole said...

I am climbing the walls too! I am worried!

Hans said...

Mr Dawg, of course the FRB controls interest rates; there is little doubt about

I have no answer for you question; best to ask the author.

IMHO, the 2008 recession was part and parcel due to governmental unit polices..It
drove the economy into an expansion which it can not sustain; along with distorting
capital investments.

Today's stock and bond markets highs are courtesy FedZero; which
has been clearly demonstrated.

Hans said...

Here is the link I failed to include:

You can see the cause and effects with the ever increase FRB increasing
balance sheet.

Hans said...
This comment has been removed by the author.
Scott Grannis said...

Re: contradictory views on the meaning of low swap spreads. (xr-3609 asked: "Are these two views as diametrically opposed as they appear to be?")

I must admit to being amazed to read that very low swap spreads in the U.S. are a sign of illiquidity and a portent of disaster, when to me they are a sign of excellent liquidity, a strong banking sector, and healthy financial markets. Need I mention that US banks are stuffed to the gills with excess reserves, making them more solid than perhaps ever before?

For now I'll make some observations which I think support my view: 2-yr swap spreads in all major markets (US, Eurozone, Canada, Japan) are either relatively low or very low from an historical perspective. Canadian 2-yr swap spreads are 28 bps, down from 42 in early July; Eurozone 2-yr swap spreads are 30 bps, only 5 bps above their post-recession lows; Japan 2-yr swap spreads are 39 bps, only 9 bps above their post-recession lows; Swiss 2-yr swap spreads are relatively illiquid, but they are trading in a range of 7-19 bps and are only 10 bps above their post-recession lows. This, despite the fact the corporate credit spreads are up meaningfully in all major markets in the past few months. The US is not an outlier, even though US swap spreads are the lowest.

Moreover, 30-yr swap spreads in all these markets are significantly lower than their 2-yr counterparts. Again, the US is not an outlier on this score.

I will continue to research this issue and will report if it turns out I'm wrong.

Johnny Bee Dawg said...


You seem to imply that stocks going up 3 1/2 times their value from their 2009 lows is "too much". However, S&P500 earnings went up more than 10 times during that same period. Earnings per share had artificially collapsed, just like stock prices did. Stocks went up less than earnings did.

That author didn't have any info on his phantom accounting changes that are allowing corporations to post extra earnings today. He just states it, as if it is a fact. I'd like to take him seriously, but the problem is, in the same sentence he also states that "the Federal Reserve is pumping money directly into the stock market." That is demonstrably false.

If you believe him, can you explain how excess reserves at banks are going directly into the stock market? Or by what other method the Fed is "pumping money directly into the stock market"?

Hans said...

Dawg, there is no nexus, other than a general directional trend between market indexes
and S&P 500 earnings..If this was the case, indexes would have dropped by 98%.

I do agree with you, that the authors link of phantom accounting changes earnings
was rather weak and was not very well articulated..He should have explain what
he meant.

That comment is a generalization but in the end, there is a means of transmission
of money..It is not well understood by me or your typical layman..The FRB, itself
is rather opaque in educating the general public, as tons of material is required
to find bits of information..By designed or accident?

Johnny, I still have over a dozen of articles to review, before I form an opinion
whether or not QE entered the economy.

This is from the BOE.

There is still a debate whether or not, reserves or excess reserves maybe
borrowed upon...It is another fundamental point I need to explore.

I axe you and others, if you were a prudent banker, would you trade your notes
and bonds, for illiquid reserves? To this date, I have had no forthcoming answer.

Unknown said...

One of my favorite bullish indicators is to track how intensely Scott, your posts are rebuffed by commenters here!

As usual. Great work, fantastic consistent analysis that has proven spot on again.

Benjamin Cole said...

Comment to no one and all: if interest rates never go back up, are such stocks as NLY good buys?

William said...

RE: two year swap spreads, inverted yield curves, recessions

I would just point out that in spite of the low swap spreads and lack of inverted yields curves, Canada experienced negative GDP growth in the first and second quarters of 2015, Japan reported negative GDP growth in the first quarter and was projected to be negative again in the second. The Netherlands, Belgium and Finland have also reported negative GDP growth (don't have the detail right at hand). And we know that major countries in South American are in recession.

My point is that in the post 2008 crisis era, slow growth is the new normal and several of the largest 20 countries have entered negative GDP growth without their swap spreads rising or having an inverted yield curve.

Scott Grannis said...

William: good points. There's lots of weak growth out there. But I would just note that Japan is the main economy where weak growth is "normal." In the past 20 quarters, Japan's has experienced negative GDP growth in 11 of those quarters, and only one quarter registered growth in excess of 1.5%. Canada's economy is dominated by commodities, which have taken a beating this past year. Even still, Canada's economy shrunk by less than 1% in the first 5 months of this year, and regained almost all of that in the subsequent two months; that probably doesn't even qualify as a recession. Eurozone growth has been tepid for years, and the region experienced a recession from late 2011 through early 2013, mostly due to the disruption associated with the sovereign debt crisis.

The U.S. has traditionally been the strongest of the developed economies, and the U.S. stands out as being the least dependent on exports. Exports account for only 13% of our GDP, whereas it is far more than that in most other economies. The U.S. doesn't easily suffer a recession.

Scott Grannis said...

Jarrod: I too enjoy the comments, especially when they are critical of my positions. It's good feedback and it helps keep me on my toes. If everyone agreed with me I would automatically think I might be wrong.

Hans said...

Ben Jamin, a lot of very critical comments within the past year
about Annaly Capital Management front office, with most negative.

There is also the suggestion, that REITS are over priced.

Johnny Bee Dawg said...

Don't people engage in swaps when they want to trade away their risk of owning fixed rates, in order to obtain a variable rate? From the bond market behavior, it looks like people are just fine holding their current coupons. Could it be that low swap spreads are also a sign that markets are pricing in lower growth, but with little systemic risk? I don't want to own a variable rate just yet. Maybe markets don't believe Yellin will act anytime soon.

Scott Grannis said...

Johnny: that's correct. Swap spreads are like the price of trading away risk. If they are low it must be because either there are not a lot of people who want to trade away risk and/or there are a lot of people who are comfortable taking on risk. Low swap spreads are thus an indication of a market that is comfortable with risk. What is unusual is that the equity market and the corporate bond market are behaving as if people are uncomfortable with risk. Trying to reconcile these positions is not easy.

Johnny Bee Dawg said...

I'm thinking that super ultra low swap spreads are a sign of negative economic outlook, but also with the outlook that the financial system will remain liquid. Excess reserves, galore. Central banks ultra accommodating. Just blabbing.