Swap spreads lead the way (3)

Another installment in this series. I first highlighted the narrowing of swap spreads back in late October/early November, and predicted that this was an important precursor of an improvement in other markets such as high-yield bonds and equities. Swap spreads are proving once again to be a great leading indicator of the health of the financial market and the economy. And the story is still playing out, as swap spreads continue to fall and are beginning to approach levels that might be considered "normal." Lower swap spreads say that high-yield debt and emerging market debt should continue to rally.

Full disclosure: I am long HYG and EMD as of the time of this writing.

Commodity recap: strong price gains

With few exceptions (e.g., wheat, corn, cattle), commodity prices have risen significantly this year. I think this reflects a fundamental improvement in the global economic outlook. Demand collapsed briefly in the fourth quarter of last year as the banking crisis sowed general panic, but it has now firmed and is likely picking up as economic life slowly returns to normal. It also reflects, as is strongly suggested by gold prices, that monetary policy is quite accommodative. Money is plentiful, and as demand and confidence returns, we are seeing some renewed interest in commodity speculation and stockpiling.

The rise in commodity prices is thus a reflection of renewed economic growth, as well as a precursor of higher inflation. Gasoline prices at the pump have jumped almost 10% this month, and since gasoline is about 5% of the CPI, that alone could give the CPI a boost of 0.5%.

I think it is very hard, in the face of this price action, for the Fed to argue that policy needs to be super-accommodative for a prolonged period in order to ensure that the economy avoids deflation and/or depression. If the Fed were following a commodity standard, they would already be taking steps to withdraw the liquidity they have injected in the past 6-8 months. By ignoring the signal of market-driven prices, and instead worrying about the supposed fragility of the recovery, they are making yet another monetary mistake.

Soaring debt + Fed monetization = higher interest rates

For many years I used this chart to show that the relationship between federal debt outstanding and interest rates was exactly the opposite of what most people tend to think: the two have been for the most part (with the notable exception being the 1990s) inversely correlated for many decades. That relationship may now be on the verge of changing: the big increase in federal debt that is slated for coming years will likely correspond to rising interest rates. The reason? Debt is going to be increasing much faster than GDP for years to come, and the Fed is making huge purchases of Treasury debt, thus monetizing the debt as never before.

Rising interest rates are thus likely to be driven by a) an avalanche of Treasury supply and b) rising inflation. These are going to be the critical issues to focus on in coming years. I don't think they mean that the economy will collapse. Instead, I think it is a good reason to expect that economic growth will be subpar (averaging less than 3%) for many years.