Are swap spreads forecasting a huge corporate bond rally?

Swap spreads tend to be leading indicators of the price of risky assets, especially in today's market. That's because the financial crisis we're struggling through is dominated by credit risk and more specifically counterparty risk. Big money is afraid to trade because of the risk that their trading partner might be the next institution to succumb to a government takeover or fall victim to plunging prices on subprime-related assets. High swap spreads represent the level of fear that is gripping the market. Markets have been frozen as a result, with liquidity all but nonexistent. With some institutions still being forced to sell assets into an illiquid market, prices have been severely depressed, and yields have soared.

Things are improving on the margin, however. Swap spreads have come down meaningfully, but are still abnormally high. As this chart shows, short-maturity swap spreads have been a good leading indicator of the distress in the junk bond market. In the past few days, yields on junk bonds have finally started to come down from the stratosphere, following the lead of declining swap spreads. If both these trends continue, high-yield bond prices are set to soar.

Job losses now confirm a recession

I finally have to drop my skepticism about this being a recession. Job losses reported today were the tipping point. Still, we're not any where near a depression. So far, this recession looks a lot like the last one as far as job losses, and the last one was the mildest on record.


If we just look at private sector jobs (ignoring government jobs because they can be created by politicians without regard to whether they are needed or not), so far we've lost between 1.5 and 2 million jobs since the peak of employment last year. (This second chart shows two different measures of jobs based on two different types of surveys, neither of which is perfect.) In the 2001 recession we lost a total of 2-3 million jobs.

Interestingly, despite the much weaker than expected jobs report this morning, the market is up. That can only mean that the market was priced to very, very bad news (I still hear lots of people talking depression). The good news is that markets are clearing, companies are restructuring, most of the subprime losses have been taken, the Fed is super-accommodative, and swap and credit spreads are coming down. Oh, and also it's good to see oil at $60/bbl rather than $150, gasoline prices down by almost half from their summer peak, the dollar up 20% from its summer lows, and industrial commodity prices down 30%. Prices in general are back to more reasonable levels, and that includes housing prices. That's exactly the sort of thing you want to see. Finally, Baltic freight rates, which had been in free-fall since May, have ticked up in the past few days. There is definitely light at the end of this tunnel.

Banks are lending by the bushel (4)

Inspired by a post by Mark Perry, I put together this chart using the latest data from the Federal Reserve. As I have noted several times before, the popular notion that the economy is at great risk because bank lending has stopped dead in its tracks is completely erroneous. Lending by all commercial banks now stands at an all-time high, and is up 9.2% in the past 12 months. I've drawn a trend line on the chart which is instructive. Over the past 36 years, bank credit has increased by a compound annual rate of 8.4% per year, only slightly faster than the 7% per annum increase in nominal GDP.

I don't see how this adds up to the assertion, as many claim, that a massive credit expansion is the root cause of our current crisis. Our current problems have nothing to do with a shortage of money or too much credit; rather, it is all about a shortage of buyers and a lack of confidence. And that in turn is being driven by the fear of defaults triggered by falling housing prices. Once prices stop falling and/or the market prices in the full extent of the likely losses, the crisis can begin to wind down. I think we're already in the early stages of that process.