Sunday, April 7, 2019

10 key charts say there's little to worry about

By now, just about everyone knows that an inverted yield curve is a sign of an impending recession. It may be a necessary sign, but it is not sufficient. It takes more than an inverted yield curve; it also takes very high real interest rates, which are the Fed's most powerful tool, to trigger a recession. Today the yield curve is only slightly and partially inverted, while real yields are still relatively low. 

An inverted yield curve is the bond market's way of saying that the Fed is expected to cut rates in the future, usually because the economy is fragile and weakening on the margin. While today there are some signs that the economy may be weakening, there are still numerous signs that the financial and economic fundamentals of the US economy are healthy, and thus the outlook for the future is still positive.

In short, the raw material for an impending recession is still lacking. We'd need to see the Fed get a lot tighter before starting to worry.

Chart #1

Chart #1 shows how every recession was preceded by an inverted curve (red line) and high real short-term interest rates (blue line). High real interest rates are symptomatic of a strong economy, but also of a shortage of liquidity. Before 2008, the Fed tightened monetary policy by restricting the supply of bank reserves. This caused the price of reserves to rise as banks competed for the reserves they needed to expand their lending activity. A scarcity of bank reserves caused liquidity conditions to deteriorate, while expensive (to borrow) money weighed heavily on weaker borrowers.

Today, it bears repeating that the Fed no longer drains reserves in order to tighten: they simply raise the rate they are willing to pay on bank reserves. Bank reserves remain abundant, with excess reserves totaling about $1.5 trillion. If the economy falls into a recession it won't be the Fed's fault.

Chart #2

Chart #2 shows the all-important spread on 2-yr interest rate swaps. Swap spreads in the US have been low for the past several years, and they are especially low today. Swaps spreads in the Eurozone are still a bit above what one would consider "normal" (10-25 bps), but they are declining on the margin. As I mentioned in my last post, declining swap spreads and rising equity prices in Europe suggest that the Eurozone economy may be pulling out of its long slump. That would obviously be very good news for everyone.

Chart #3

Chart #3 shows spreads for 5-yr generic Credit Default Swaps. This is a timely and liquid indicator of the market's outlook for corporate profits—with lower spreads reflecting increasing confidence. Credit spreads today are quite low. The market may profess to be worried about a weaker economy, but the appetite for credit risk remains strong. 

Chart #4

Moving on to the yield curve, Chart #4 shows overnight real yields (blue line) and the market's expectation for what overnight real yields will average over the next 5 years (red line). Here we see a modest inversion of the front end of the real yield curve (because 5-yr real yields are less than overnight real yields), which further suggests that the market believes the Fed will lower its funds rate target once or twice in the foreseeable future. This is arguably evidence that the market thinks the Fed is "too tight" and will be forced (or coerced?) into cutting rates at some point. But it is not a prediction that the economy is going to suffocate for want of liquidity and high borrowing costs. 

Chart #5

Chart #5 is the most popular measure of the shape of the yield curve: the difference between 2- and 10-yr Treasury yields. Here we see the curve has had a mildly positive slope for the past several months. But it is not flat or inverted. We've seen periods like this in the past that were not followed by a an imminent recession. 

Chart #6

Chart #6 looks at the slope of the long end of the Treasury curve (over which the Fed has very little control or influence). Here we see that the curve is definitely upward-sloping. It was like this for several years in the mid-1990s, when the economy was booming.

So: yes, parts of the yield curve are flat or inverted, but it's not necessarily because the market expects or senses that a recession is looming. Meanwhile, real yields are still relatively low and liquidity conditions could hardly be better. This is not the stuff of an impending recession.

Chart #7

Chart #8

Moving on to the labor market, Chart #7 shows that first-time claims for unemployment are at record lows. Relative to the size of the labor market, claims are an order of magnitude lower than they have ever been before. This is nirvana for the average worker, since it means the likelihood of losing one's job today is as low as it has ever been (see Chart #8). No wonder consumer confidence remains high.

Chart #9

Chart #9 shows the growth rate of private sector jobs (the ones that really count) over rolling 6- and 12-month periods. (It's foolish to look just at monthly numbers, since they are notoriously volatile.) Here we see a modest weakening in growth of late, but nothing serious.

Chart #10

Finally, Chart #10 shows that the market's general level of concern/anxiety (as measured by the ratio of the Vix index to 10-yr Treasury yields) has been declining as equity prices have almost completely retraced their 2018 year-end selloff.

I can't say the economy is booming, but I do think the economy's fundamentals remain healthy. The Fed is not making any obvious mistakes, the dollar is reasonably strong and relatively stable, overseas equity markets are rallying along with ours, regulatory burdens are declining, consumer confidence is high, tax burdens have been cut, especially for businesses (the ones who are the job creators and the drivers of rising prosperity), gold prices are relatively flat and trendless, industrial commodity prices are rising, and it appears that we are gradually coming to an agreement with China on trade and intellectual property rights (i.e., the risk of a trade war is definitely declining). Thus, it pays to remain optimistic.

P.S. Sorry it's been so long since my last post. We've had a rather busy travel schedule (Chile, Argentina, and Italy) which will be winding down over the next few days.


AmmoCannon said...

Scott! Great work as always. You keep me tracking in the right direction. One question, I have been reading more and more about a BOP issue for the US and with this weeks Trump demand to cut 50bps and restart QE that seems to be a more realistic issue. I have heard that it might be best for the US to devalue the dollar by 30% to help us get out of our huge debt and enntitlement situation. Thoughts??

Scott Grannis said...

The BOP "issue" is not a problem at. We have a trade deficit because we have a capital surplus. It's a problem that foreigners want to invest in our economy rather than buy our stuff?

Devaluing the dollar would be a terrible "solution" to any problem. A weaker dollar would destroy confidence, scare away investment, weaken the economy and cause inflation to rise.

We do indeed have an entitlement problem. But the best way to fix it is to grow the economy and restrict access to entitlement programs (e.g., means testing, raising the retirement age, indexing payments differently).

One huge thing we could do is privatize social security. As it is, social security is the biggest scam ever foisted on the American public.

Popo Dean said...

Thanks Scott.

Any additional comment re: Chart #1 and real rate posting consistently lower highs prior to recessions? Suggests, at a minimum, that maybe we won't have to go as high as typical in the past?

Thanks in advance.

Al said...

Great to see you back Scott. Missed your blog.

Benjamin Cole said...

Yet another terrific wrap up by Scott Grannis.

It may be the Federal Reserve has finally learned its lesson, and that in today's world the task is monetary stimulus not the heroic fight on inflation. I think the Federal Reserve was within one rate hike or two of triggering a recession but has pulled back.

I can deliver the fire-and-brimstone sermon on inflation with the best of them, but the world has changed. Several nations, including Japan, Germany, Austria and Switzerland, are selling bonds with negative interest rates.

I agree that interest on excess reserves has become a monetary policy tool. And yet I wonder how much banks would lend out even if there were no interest on excess reserves. After all, banks will not make a loan unless they think they will get paid back with interest.

I hope the Fed targets robust growth for the next couple generations. No one seems sure why, but the inflation horse has died on the stretch. You can whip that pony all day long but he's not getting up.

Roy said...

"The BOP "issue" is not a problem at. We have a trade deficit because we have a capital surplus."

Capital inflows should be taxed. That's the best way to rebalance the economy and decrease inequality.

Scott Grannis said...

Roy: If you tax something you always get less of it. Why would we want less capital? Less investment? That makes no sense. Capital and trade flows are what they are; any attempts to “rebalance” things will only end up—like all government efforts to intervene in the markets—producing unexpected and usually perverse results.

Christophe said...

(please no politics just pragmatic opinion from experience)

- The president is nominating Stephen Moore for the Fed. Stephen seems to have been very wrong most of the time as a journalist. Isn’t that concerning, in the sense that when the next crisis/recession comes it might endup being severe giving what appears to be many grossly incompetant individuals? When times are good, a bad pilot will do, but when the turbulence is severe it requires an excellent one?

- We have seen how quickly liquidity seems to be able to dry up (Munchin consulting the big bank last year..and more over the last years...etc..) Does it appear this nearly instant liquidity dryup is something new? Maybe due to 2008/2009 trauma, more algorithmic trading, instant Information Age...etc?

Thanks Scott for spreading so well your knowledge and enjoy your travels with wife.

The Cliff Claven of Finance said...

The Household Survey for March 2019
reflects fewer people working
than in November 2018.

That's a very unusual divergence
from the Payroll Survey.

The Household Survey
is more accurate
in the months just before
a recession begins,
but all employment surveys
are LAGGING indicators.

The Payroll Survey
tends to need huge
negative revisions
in the months
just before,
and just after,
a recession begins.

The Cliff Claven of Finance said...

The S&P 500 index was 2,872.9
at the January 26, 2018 high.

A few minutes ago,
the S&P 500 index was 2,887.5,
for a tiny gain of +0.5% in over 14 months !

Something is concerning stock investors
about the US economy that may not be
obvious in any charts.

minnesota nice said...

Following up on Unknown - Do fixed asset ETF/Funds give a perception that there is more liquidity than there is? It's a lot easier to sell an ETF than a bond. It seems we got a small taste of illiquidity at the end of 2018 when there was no issuance in high yields.

The Cliff Claven of Finance said...

Economic news almost ALWAYS
look good just before a recession begins:

Each of the dates below
shows the real GDP
annual growth rate
of the economy
immediately prior to
the start of a recession

( this is historically revised data,
not what was released at the time,
which was usually better than what you see below ! ).

Real (inflation-adjusted)
economic growth rates:
• September 1957: 3.07%
• May 1960: 2.06%
• January 1970: 0.32%
• December 1973: 4.02%
• January 1980: 1.42%
• July 1981: 4.33%
• July 1990: 1.73%
• March 2001: 2.31%
• December 2007: 1.97%

brave chicken said...

My one junky chart says the buyer needs to be critically aware that we are in a very weak period, that most likely doesn't have a happy ending. Best case, we stagger along with little growth, watching little up and down moves that amount to zero!

Percent change:

10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity, Percent, Not Seasonally Adjusted (T10Y3MM)

10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity, Percent, Not Seasonally Adjusted (T10Y2YM)

S&P 500, Index, Not Seasonally Adjusted (SP500)

Roy said...


1. You would want to tax capital inflows when they have a negative impact on the economy, and they can. The U.S. is not lacking money, see your own data.

2. It's good to remember when the "balance" word is used that the American market is not a closed market. The world is a closed market, and most people in the world live in closed non-market economies that have an impact on our economy. In recent years, a very large closed non-market economy has risen and it is having a huge impact. The impact is significant. If you want to reach "balance" within our own economy you have to intervene. There's no other way.

Roy said...

Just to add a bit regarding the current ""tariffs war"", one of the main reasons the tariffs will not decrease the trade deficit is that the trade deficit is mainly due to these excessive capital inflows which are the result of excessive savings in the countries from which they arrive. And, of course, having reserve currency obviously has a cost. So, if you want to "balance" things out, start with refusing to have the USD on its own as a reserve currency and let other countries deal with their own imbalances instead of dumping it on us and letting us deal with.

Scott Grannis said...

Roy: Your quest for "balance" is disturbingly similar to progressives' search for income and wealth equality. Both are very subjective concepts, and both require heavy government intervention in the private economy. Neither one has ever demonstrated the ability to "improve" things. What they have shown is that they increase the power of the state at the expense of the individual. That typically results in the finding that the people who benefit the most from state intervention are the members of the ruling class. As I said before, intervention usually produces unexpected and typically perverse results.

Roy said...


You are saying that Party B (US government) should not intervene in Party A (US economy).

I am saying:

Party C (Foreign country C government, with a closed non-market economy close to the size of Party A.) is intervening in a very significant way in Party A for many years now.

You are saying: Party B(US government) should do nothing about it! Let the market handle it by itself.

I am saying: if Party B does nothing about it and leave it to the market, you will lose. We already have.

I am also saying:

Party B is ALREADY intervening and manipulating and what not for many years, for many decades. This is the reality, right now. Shall we just pretend this reality does not exist?

bravechicken53 said...

The only chart that matters: GDP, stocks and housing growth as percent -- this is reality not hype or philosophical adjustments.

bravechicken53 said...

Reality versus hype

Don Harrison said...

Just wanted to say "thank you" for all the great work you do. Your charts and commentary are a great help determining where we are in the business cycle.

Scott Grannis said...

Don: Thanks for your comment!