Credit spread update: still looking good

Credit spreads typically are good coincident and leading, market-based indicators of the health of the U.S. economy. Although they are still somewhat higher than they have been in the past—during times of normal growth and relatively tranquil conditions—they show almost no sign of concern and are consistent with an economic expansion that is ongoing.

Swap spreads—proxies for AA bank credit risk and highly liquid—have been the best leading indicators of trouble ahead. The chart above provides a long-term history of 2-yr swap spreads. (See here for a more detailed explanation of swap spreads.) Swap spreads have risen in advance of every recent recession, and have declined meaningfully in advance of every recent recovery. Currently they are about as low as they have ever been. This is symptomatic of very healthy liquidity conditions in U.S. financial markets, generally low default risk, accommodative monetary policy, and very low systemic risk.

The first of the above charts focuses on the past six years, and compares U.S. swap spreads to their Eurozone counterparts. Eurozone swap spreads are still somewhat elevated, but that is not surprising given the ongoing problems with sovereign default risk in the Eurozone. It is comforting to see that Eurozone swap spreads have been relatively stable for most of the past year. This has proven to be a good leading indicator of economic conditions in Europe, which are improving, as shown in the second chart (note that swap spreads are inverted, to show that declining spreads point to improving conditions); Eurozone manufacturing is pulling out of its two-year slump and the Eurozone economy may therefore soon be emerging from recession.

Credit default swap spreads are highly liquid, generic indicators of corporate default risk. They are now very close to post-recession lows, although still higher than their pre-recession lows. This suggests some ongoing concerns, but that is not surprising given that the U.S. economy is still mired in a disappointingly slow recovery. On the bright side, however, generally low and stable credit spreads show that the corporate sector is generally quite healthy.

As the above chart shows, swap spreads were good leading indicators of junk bond spreads before and during the recession. With swap spreads very low and stable, high yield spreads should at least be relatively stable and likely have room to fall further.

This last chart gives a long-term look at credit spreads for the investment grade and high-yield corporate bond sectors. Spreads are still relatively attractive compared to their historical lows, and they have been largely unaffected by the recent 100 bps rise in 10-yr Treasury yields. This is the bond market's way of saying that higher Treasury yields pose little or no threat to the economy.

Credit spreads tell a bullish story

Credit spreads—the extra amount of yield that investors demand to hold debt that is riskier than Treasuries—are uniformly low these days. That tells us that liquidity in the bond market is abundant, systemic risk is low, and the outlook for corporate profits and the economy is healthy. '

Swap spreads (see a short primer on swap spreads here) are arguably the bedrock and most important of all credit spreads. "Normal" spreads on 2-yr contracts are roughly 20-40 bps. At today's 25 bps, 2-yr swap spreads are perfectly normal. This tells us that bond market liquidity is relatively abundant. Fed tightening has not created a shortage of money, as it usually does in advance of recessions. It also tells us that systemic risk is perceived to be low. As the chart above suggests, swap spreads tend to be good predictors of conditions in the broader economy; spreads tend to rise in advance of recessions and decline in advance of recoveries.

As the chart above shows, swap spreads in the Eurozone are elevated. Conditions are not as healthy there as they are here. Eurozone spreads are not dangerously high, but they do reflect some systemic risk, which is likely related to the perception that the Eurozone still faces existential risks from countries thinking about "exiting" the Eurozone. Given the higher spreads in the Eurozone, it is not surprising that Eurozone GDP growth has been lagging that of the US for a number of years. Riskier markets tend to receive less investment—and consequently less growth—than less risky markets.

The chart above shows credit spreads as derived from the universe of bonds issued by US corporations: $6.3 trillion of investment grade bonds, and $1.3 trillion of high-yield (junk) bonds. Both spreads are relatively low, as you would expect them to be in a healthy, growing economy. They are not at record lows, but they are low enough to be impressive.

The chart above compares 2-yr swap spreads to high-yield corporate spreads. Here we see further evidence of how swap spreads tend to be good predictors of the health of the economy (HY spreads are particularly sensitive to the underlying health of the economy).

The chart above shows 5-yr Credit Default Swap spreads. CDS spreads are derived from generic contracts representing hundreds of large, liquid corporate bonds, so they are reliably good proxies for overall credit risk. Their message is the same as other credit spreads: conditions are normal, and thus the outlook for the economy and corporate profits is healthy.

Reading the market tea leaves: swap and credit spreads still relatively benign

Swap spreads are excellent coincident and forward-looking indicators of the general health of the financial markets and the economy. (See my short primer on the subject here.) They are therefore one of the most important indicators for investors to follow. The news of late has been mixed to negative, with a modest pickup in growth in the U.S. economy overshadowed by increased tensions in the mideast, weak economic growth in Europe, the return of the "Grexit" problem (the potential for a default on the part of the Greek government, or a decision to leave the Euro), the collapse of oil prices (which has threatened the economic viability of Russia, Venezuela, and heavily indebted oil companies), and the ongoing slowdown in China (which nevertheless continues to grow at a pace that would be the envy of every other nation on the planet). On net, markets have gotten worried, as I've noted in many numerous posts of the "climbing walls of worry" variety.

To judge by the level of swap spreads, however, the problems that beset many parts of the world are not particularly worrisome. Swap spreads remain relatively low, with the bulk of the widening confined to the energy sector. Even there, we find that spreads have narrowed in recent weeks from their initial panic highs. The following charts tell the story:

The chart above emphasizes the role of Quantitative Easing in both the U.S. and Europe. QE's major impact was directed to the financial markets (not to the economy, as so many assume), since QE basically involved the provision of liquidity to the banking system: the Fed purchased notes and bonds and paid for them with the issuance of bank reserves, which are functionally equivalent to T-bills. 2-yr swap spreads. Banks needed liquidity and the world's investors were desperate for safe asets—both were in very short supply—and QE addressed that problem. But QE1 and QE2 were both ended prematurely, as evidence by the widening of swap spreads that occurred around the time of their demise. QE3, on the other hand, ended at the right time. Swap spreads have only increased marginally since the end of QE3, mainly because of the concerns surrounding Greece, falling oil prices, etc., that I mentioned above. The current level of swap spreads is fully consistent with "normal" financial market conditions.

The chart above shows 2-yr swap spreads in an historical context. Here again we see that the current level of spreads is relatively benign. The world's investors may think there is a lot of risk out there, but swap spreads tells us that the financial system is able to support the risk. Markets can manage risk very efficiently if the government refrains from intervening.

The biggest source of risk these days, arguably, is the stress that many oil producers are feeling as the result of the almost 50% decline in petroleum prices since last summer. Spreads on high-yield, energy-related debt spiked several weeks ago, but have since subsided somewhat. Oil prices have stopped declining, and the market has had a chance to better assess the risks involved. The oil industry is facing a big problem, but at this point it does not look like it will intensify or prove contagious to the rest of the world.

The chart above shows the average level of credit spreads for investment grade and high yield debt. Spreads are up from their lows, but they are still quite low from an historical perspective.

On balance, therefore, swap and credit spreads in general are telling us that the likelihood of a major economic or financial market collapse is very low. We are not on the cusp of another recession or another Great Recession. We're more likely in the midst of the sort of one of the run-of-the-mill problems that beset markets from time to time and that are eventually resolved without serious consequences.

Spread monitor: looking good

Often, prices alone cannot tell the story. Knowing a stock has gone up 10% is nice, but if that happens in the context of the broad market rising 20% then it's not so nice. In the bond market, comparing one yield to another is essential to understanding value. Virtually every bond in the world is priced relative to Treasuries of comparable duration or maturity. The Treasury yield curve is the "backbone" of all yield curves; it sets the gold standard for yields of all maturities because Treasuries are the most liquid, risk-free securities in the world. Without the Treasury yield as a universal benchmark, the bond market would be much less efficient.

Looking at the "spread," or difference between the yield on, say, a corporate and a Treasury bond of similar maturity is essential to understanding the value of that bond, which in turn depends on how risky the market perceives its issuer to be. The greater the spread, the riskier, and the smaller the spread, the safer. Spreads can also tell us about the health and underlying liquidity conditions of the market as a whole. And by inference, spreads can also tell us about what the outlook is for the economy, since a healthy financial market is essential to a healthy economy.

The following charts cover the spreads I consider essential to understand the economic and financial fundamentals. Fortunately, they are all telling a good story.

Chart #1

Chart #1 looks at the "TED" spread, which is the difference between the yield on 3-mo. LIBOR securities and 3-mo. T-bills. (The acronym TED comes from Treasury vs EuroDollar.) LIBOR is a standardized measure of short-term yields of dollar-denominated securities which trade overseas in what is commonly referred to as the eurodollar market. The TED spread is equivalent to the extra yield over risk-free T-bills that investors require to accept the credit risk of a major overseas bank, since it is those banks that pay LIBOR when they borrow. Long story short, the TED spread is a good proxy for how risky the global banking system is. Current spreads are about 15 bps, which is the difference between the 25 bps yield on 3-mo. LIBOR and the 10 bps yield on 3-mo. T-bills. That's about as low as the TED spread has ever been, and that's a very good thing, because it means global financial markets are in very good shape.

Chart #2

Swap spreads are the extra yield that investors require to enter into a swap agreement with a major broker-dealer or financial institution. Swap agreements involve one party paying, for example, a fixed rate to another party and accepting a floating rate in return. Swap transactions effectively allow investors and financial institutions to efficiently manage their risk. You can find a longer explanation of swap spreads here.

Chart #2 looks at 2-yr swap spreads, which is the extra yield that one party requires in order to enter into an agreement in which the investor receives a floating yield in exchange for paying a fixed, 2-yr yield. 2-yr swaps represent a highly liquid market and are thus an excellent proxy not only for the health of financial markets but also the general liquidity conditions of financial markets (a high degree of liquidity leads to very low spreads). Current swap spreads in the US are very low, while spreads in the Eurozone have clearly moved into "healthy" territory after spending many years in not-so-healthy territory.

Bottom line: swap spreads tell us that global financial markets are in very good shape, and that can often be a good predictor of future economic health. They also tells us that central banks for the most part are not a threat to the markets or the economy. No one is being starved for liquidity, and real interest rates (and thus borrowing costs) are extremely low. Note also that this predictive ability of swap spreads can be seen in Chart #2, as swap spreads rose in advance of the 2008 recession and fell in advance of the recovery.

Chart #3

Chart #4

Chart #3 shows 5-yr Credit Default Swap spreads. CDS spreads are a very liquid market that gives a good proxy for 5-yr corporate credit risk. Spreads are trading at pretty low levels, suggesting that credit risk is minimal, and by extension, that investors perceive the outlook for the economy to be healthy. Chart #4 shows the difference between investment grade and high yield CDS spreads, something that is called the "junk spread." This too is a good proxy for the extra risk an investor experiences as he or she ventures into the junk bond arena.

Chart #5

Chart #5 is an amalgamation of the credit spreads on two classes of corporate bonds of all maturities—and there are many. Here again we see that spreads are generally low, thus the implied outlook for the economy is healthy. Investors are not overly concerned about the outlook for corporate profits. 

Chart #6

Chart #7

Charts #6 and #7 show the spreads between nominal and real yields on Treasuries and TIPS (TIPS = Treasury Inflation Protected Securities). This difference, or spread, is equivalent to the market's expectation for future annual inflation rates. In both cases, it appears the market is expecting consumer price inflation to average just over 1.5% per year for the foreseeable future. If this proves to be an accurate forecast I—and most people—will be happy. I worry, however, that the Fed wants the inflation rate to be higher, and I've learned to never doubt the Fed's ability to get what it wants.

It's important to realize that most people's understanding of how inflation works is faulty. Inflation is not a by-product of strong growth or strong demand. Inflation happens when there is more money in the system than people want to hold. Inflation lies in the intersection of a central bank's willingness to supply money and the public's desire to willingly hold that money. Too much money is what leads to inflation. There is certainly plenty of money these days, as I have documented in prior posts. What is keeping inflation in check is the apparent fact that the public is happy to hold all that money, because there are still many things to worry about and money provides security.

What we need to be attentive to is the return of confidence, since that will act to reduce the demand for money. And if the Fed doesn't react to this by increasing short-term rates in a timely fashion, we will end up with higher-than-expected inflation and eventually much higher interest rates as the Fed is forced to tighten monetary conditions. This is how almost every recession (except this year's) has started, by the way, so it's not a pleasant prospect. Fortunately I don't see this happening any time soon, but next year is still out there on the horizon.... 

Key indicators are still healthy

This post recaps the market-based indictors that I think are very important to follow. On balance things look quite favorable. As always, all charts contain the most recent data available as of today (with a few exceptions, as noted, where I have estimated the latest datapoint).

Chart #1

I like to begin with 2-yr swap spreads (Chart #1), since they have proven to be excellent leading and coincident indicators of the health of financial markets and of generic or systemic risk (the lower the better, with 15-35 bps being a "normal" range). A more lengthy discussion of swap spreads can be found here. Currently, swap spreads are almost exactly where one would expect them to be if markets were healthy and the economy were growing comfortably. The current level of swap spreads also tells me that liquidity is abundant; i.e., the Fed has not squeezed credit conditions nor tightened enough to disturb the underlying fundamentals.

Note that swap spreads have increased meaningfully in advance of past recessions and have declined in advance of recoveries. At current levels, swaps are consistent with healthy financial markets and an improving economy.

Chart #2

Chart #2 shows the same 2-yr swap spreads over a shorter period, and it adds Eurozone swap spreads for comparison. I note that conditions in the Eurozone have not been as healthy as in the US for some time now, but conditions do appear to be improving on the margin of late. Not surprisingly, Eurozone stocks have underperformed significantly over the past decade. All eyes are thus on the US as the world's growth engine.

 Chart #3

Bloomberg publishes an index of financial conditions which incorporates a wide variety of market based indicators, shown in Chart #3. In contrast to the swap spreads chart, higher values of this index are good. Here again we see that financial conditions are healthy and have rarely been better.

Chart #4

Chart #4 shows 5-yr CDS spreads (credit default spreads). These instruments are widely utilized by institutional investors, and are considered to be a highly liquid proxy for generic credit risk. Today, CDS spreads are rather low, which is good, though they have at times been lower. As with swap spreads, these spreads tend to rise in advance of economic trouble. So far they show not sign of any threats.

Chart #5

Chart #5 shows average credit spreads for investment grade and high yield corporate bonds. They tell the same story as CDS spreads: conditions today are healthy. The bond market is not concerned about credit risk, nor is it concerned about downside risks to the economy.

Chart #6

Chart #6 is a classic, since it shows how Fed tightening has preceded every recession in the past half century. Monetary tightening shows up in different ways: 1) in the level of real short-term interest rates, over which the Fed has direct control, and 2) in the slope of the yield curve. When real short rates rise significantly and the yield curve becomes flat or inverts, a recession eventually follows. Today many worry that the yield curve is almost flat, but it's important to view this in the light of very low real short-term rates. This combination tells me that the Fed has not yet begun to tighten monetary policy. The current slope of the yield curve tells us that the market expects the Fed to raise rates gradually, and not excessively. To date, the various hikes in the Fed's target rate have served mainly to offset a gradual rise in inflation over the past year or so. At its current pace, the Fed is likely years away from becoming "tight."

Chart #7

Chart #7 compares the nominal yield on 5-yr Treasuries to the real yield on 5-yr TIPS (inflation-indexed bonds). The difference between the two is the market's expected average rate of consumer price inflation over the next 5 years. Inflation expectations are relatively stable, and at 2%, they are almost exactly what the Fed is targeting. From this we can assume the Fed is doing a reasonably good job of balancing the supply and demand for money. This should be comforting and reassuring to a market that continually frets that something might be on the verge of going wrong.

Chart #8

Chart #8 compares the real yield on 5-yr TIPS to the inflation-adjusted (real) yield on the overnight Fed funds rate. The latter is the same series shown in the blue line of Chart #6 above. The comparison of the two here is important, since the red line is effectively the market's best guess as to what the blue line will average over the next 5 years. This is thus another way of judging the slope of the yield curve. A true yield curve inversion would almost certainly find the blue line exceeding the red line, as it did prior to the past two recessions, since this implies that the market expects the Fed to ease monetary policy in the future, presumably because of deteriorating economic health. According to Chart #8, the front end of the real yield curve is steepening, not flattening, and that is good.

The market is mistakenly focusing too much attention on the nominal yield curve. The real yield curve is more important, and its current message is definitely positive.

Chart #9

Real yields are driven in large part by the Fed's actions, especially in the very front end of the yield curve. However, 5-yr real yields are also driven by the market's perception of the health of the economy. Chart #9 shows how the level of real yields tends to follow the economy's trend growth rate. Currently, real yields are rising slowly, in line with the gradual strengthening of economic growth. There is no sign here of excessive optimism. If anything, both the market and the Fed are behaving in a cautiously optimistic manner.

On balance, all of these indicators are in healthy territory. Consequently, it is reasonable to assume that the economy is going to be growing for the foreseeable future. Systemic risks are low, inflation expectations are low and stable, and liquidity is abundant. The Fed has been doing a good job, and there is no sign they are going to upset any applecart. There's not much more you could ask for at this point.

We don't live in a risk-free world, however. For now, what risks there are, are concentrated in the trade-related sectors, thanks to the tariff wars that Trump seems to relish. Trade risks are undoubtedly acting as a headwind to growth, without which the market might be getting quite enthusiastic about the future.

UPDATE (9/11/18): Chart #10, below, shows just how dramatically US stocks have outperformed their European counterparts. An investment in the S&P 500 has returned 22% more than a similar investment in the Euro Stoxx 600 since just before Trump's election.

Chart #10

Swap spreads explained

In response to some recent questions, here is a short summary of what swap spreads are. You can also find stuff on wikipedia. I follow swaps spreads via Bloomberg, but unfortunately they are not readily available to the general public.

Swaps are transactions that allow people to redistribute risk. They are over the counter agreements between any two parties to exchange one cash flow for another. The most basic swap is fixed rate for floating rate payments. If I own bonds (fixed rate instruments) but I worry about the prospect of interest rates rising, I might want to reduce my fixed rate exposure by entering into a swap with someone else; I would pay him the fixed rate I receive on my bonds and he would pay me a floating rate, typically Libor. I reduce my risk that way, and he increases his. He also becomes exposed to the risk that if interest rates fall, I might renege on my promise to pay him a fixed rate and he might lose out on the profit inherent in his position. In order to compensate him for these risks I need to pay him the fixed rate plus a little extra, which is the swap spread: the difference between the rate I am paying him and the rate on a Treasury bond with a maturity equal to the term of the swap agreement.

So swap spreads are a lot like credit spreads since there is counterparty risk involved. Swaps have mechanisms such as collateral agreements to minimize counterparty risk, and so can be thought of as equivalent to the spread on a AA-rated bank bond. Swap spreads are also a barometer of risk aversion in the marketplace. The more people want to swap out of their risky exposures, the more they must be willing to pay to induce others to accept that risk. So rising swap spreads equate to more risk aversion. Swap spreads can be thought of as barometers of systemic risk for the same reason.

Swaps are extremely liquid markets (much more liquid than the corporate bond market, where everything is quoted on a spread to Treasuries basis) and represent a key mechanism for the transfer and/or redistribution of risk among large institutional investors. They help make markets efficient. When they all but shut down, as they did in September, that is a sign that liquidity has dried up because a) everyone wants to reduce risk, and b) everyone is terrified of entering into any transactions because they are unable to quantify the risks out there.

Swap spreads during normal times and normal markets typically trade in the range of 30-40 basis points.

There are swap markets for all sorts of thing: interest rate swaps, credit default swaps, index swaps, currency swaps, etc.

Short version:

Swaps are agreements between two parties to exchange cash flows. In a typical swap, A pays a fixed rate of interest to B, and B pays a floating rate (Libor) to A. A also needs to pay B a spread above the fixed rate to compensate him for the increased risk he takes on.

Swap spreads are thus an indicator of how willing people are to transact with each other, how much it costs to reduce your risk, and how liquid the market is. Swap spreads can also be thought of as representing the riskiness of a generic AA rated bank--the higher the spread the more risky banks are perceived to be.

The swaps market is huge but generally restricted to large institutional investors and broker-dealers.

Trends in key asset markets look healthy

In recent months there have been a number of interesting developments in global asset markets. In general it's all good news: the dollar is strengthening, gold is teetering, interest rates are rising, commodities are resilient, equities are rising, credit spreads are narrowing, and emerging markets are recovering. Not everything is rosy, however, but on balance the market's message is that global economic growth is expected to improve for the foreseeable future, while inflation is likely to remain relatively low and stable.

I continue to believe that there is a lot of upside potential in the U.S. economy, and I that the outlook for corporate profits is improving now that oil prices are no longer declining and confidence is on the rise. What's changed to make all this possible? The direction of policy: after years or moving in the wrong direction, regulatory burdens going forward are likely to decline, marginal tax rates are likely to decline, the U.S. tax code is likely to be simplified, and markets are likely to become freer and fairer. Trump may not do everything right, but as long as he fixes at least a few things, we'll be better off in the future than we have been in the past.

From my supply-side perspective, this means that the incentives to work, invest, and take risk are on the cusp of rising, and so in coming years we are likely to see more people looking for work, more jobs being created, stronger productivity gains, and expanding trade and prosperity globally. It's hard to say how much improvement there will actually be, but the important thing is that on the margin, things are likely to improve. That's what moves markets: the direction of change on the margin relative to expectations for change.

Here are 20+ charts that tell the story:

The value of the dollar is arguably one of the most important financial variables, since it is effectively the price of admission to the world's biggest, wealthiest, and most influential economy. A rising dollar is thus a good sign that the world is more interested in gaining exposure to our economy, and that in turn means more investment and more growth—it's a virtuous cycle. The chart above is arguably the best measure of the dollar's value vis a vis other currencies, since it is calculated on a trade-weighted, inflation-adjusted basis. It was only a few years ago that the dollar was scraping the bottom of the barrel, trading at all-time lows. Back then it was far from clear whether the U.S. would ever recover its former glory, or ever manage to grow by more than 2% a year. Today, in contrast, animal spirits are making a comeback. Hope is returning.

Today's ADP employment report, which far exceeded expectations, was at least a partial sign of a revival in animal spirits. But as the chart above shows, we have seen quite a few spikes like this in prior years, only to have them reversed in subsequent months. In other words, it's too early to be confident in a significant and lasting pickup in hiring. Nevertheless, since this report comes on the heels of a very strong jump in Small Business Optimism (second chart above), it is reasonable to be optimistic.

History tells us that the value of the dollar and the price of commodities tend to move in opposite directions (see chart above, which compares commodity prices to the inverse of the dollar's value). It's rare that commodity prices should be as strong as they are today given the dollar's impressive rise in recent years. I continue to believe that this signals that a stronger dollar is a harbinger of a stronger U.S. economy and a stronger global economy, and that is what is keeping commodity prices resilient.

Credit Default Swap spreads, shown in the chart above, are a highly liquid market that is an excellent proxy for the market's outlook for corporate creditworthiness. Spreads today are as low as they have been for many years, but they are not yet at the rock-bottom lows we saw in the late 1980s. The message is simple: the market is not very worried about creditworthiness, presumably because the outlook for the economy has improved and there are as yet no signs of deterioration. If there's anything to worry about, it's that spreads are relatively narrow, and that is a sign of optimism. And when optimism is high the market becomes vulnerable to anything that is not good news.

Swap spreads, shown in the chart above, are a unique form of credit spread because they reflect both the health and the liquidity of the financial markets and they are often good leading indicators of the health of the economy. Swap spreads are the market's way of charging for generic risk when entering into large and complex financial transactions with major financial participants. That swap spreads both here and in the Eurozone are rising is therefore a reason to worry. I hasten to note, however, that U.S. swaps spreads, currently about 30 bps, are still within a "normal" range, which would be 20-30 bps. The time to worry is when swap spreads exceed 50-60 bps. Unfortunately, Eurozone swap spreads are now in the worry zone. I think this probably reflects rising concerns in Europe that the French government may decide to exit the EU (i.e., "Frexit"), and if they do, this could pose significant systemic risk for Eurozone financial markets. I note in that regard that 5-yr CDS spreads on French government bonds have spiked to 60-70 bps in recent months, while German government CDS spreads remain relatively benign. In short, markets are worried that the French could do something "stupid" that might in turn lead to defaulting on its obligations. This bears watching, but it's not yet a reason to panic. The world started to panic over Brexit, but since then it has proven to be more a development that is more salutary than concerning.

The chart above compares swap spreads with the spread on high yield corporate debt. Here we see an anomaly: swap spreads are rising while HY spreads are declining. This could be one of those times when swap spreads are the leading indicator for where the rest of credit spreads are headed. For the time being, however, I am more persuaded by the fact that swap spreads are still pretty normal at current levels, so their recent rise is more in the nature of a return to normalcy than it is to the beginnings of deterioration. If they continue to rise in a meaningful fashion, then I'll start to worry that other credit spreads might rise, and the outlook for the economy would therefore deteriorate.

In the two charts above, we see that Commercial and Industrial Loan growth has slowed down significantly in the past four months, after growing at heady, double-digit rates for years. Is this a cause for concern, or is it simply a return to more normal conditions? A slowdown in loan growth is symptomatic of an increase in the demand for money (because wanting money is the opposite of borrowing money). As such, this may well be a healthy development; banks are not lending willy-nilly, and neither are companies borrowing with abandon. It's also important to remember that lending activity does not necessarily drive economic growth; lending can facilitate growth, but it can't create growth out of thin air. Confidence and investment are the keys to growth, and a slowdown in lending activity could be simply a sign of returning confidence. Meanwhile, we know that there is no shortage of money in the system.

The two charts above suggest that bank lending is on solid ground, at least for now. Delinquency rates for both C&I Loans and all bank loans and leases are historically low. To be sure, delinquency rates are more of a coincident than a leading indicator, since companies typically have problems paying off their debts when the economy is deteriorating or very weak. In other words, recessions are not caused by loan defaults; loan defaults are the result of recessions. In any event, these charts tip the scales in favor of rational lending and borrowing behavior.

The chart above has fascinated me for years, since it shows that the prices of TIPS and golds have been highly correlated (the blue line is the inverse of the real yield on TIPS, which is a good proxy for their price). Both of these disparate assets are moving together: how to explain? My best guess is that they share one key attribute, which is "safety." Gold is a classic refuge from uncertainty, and TIPS are not only default-free but government-guaranteed to protect against inflation. That both appear to be declining on the margin suggests that financial markets are becoming somewhat less risk-averse, presumably because the outlook for growth is improving. If the economy becomes healthier, there is less reason for the Fed to take outsize risks, and thus there is less risk of inflation and less risk of a debasement of the dollar. I'd like to see both assets continue to decline in price.

The chart above compares the real and nominal yield on 10-yr Treasuries, with the spread between the two being the equivalent of the market's expected annual rate of inflation over the next 10 years. Inflation expectations have been "anchored" around 2% for several months now, even as yields have reached new highs for the year. This in turn suggests that it is real rates that are driving all rates higher, which implies that rates are rising because the market's growth expectations are rising (real rates typically rise as economic growth picks up). The rise in real rates is still quite modest, however, but it is encouraging and I would expect to see more of the same in the months to come.  

One reason the dollar is stronger these days is that other currencies have become less attractive (see charts above). Both the Euro and Sterling are now trading "cheap" relative to my estimate of their Purchasing Power Parity vis a vis the dollar. The dollar is not worth more because the Fed has created a shortage of dollars (which would be deflationary); it is worth more because other currencies are worth less. For that reason I doubt that the dollar's strength is a harbinger of rising deflation risk. It's one more sign that the U.S. economy is attracting the world's capital, and that capital can in turn fuel more investment and growth in the years to come.

The chart above shows that a rising dollar can often be a precursor of rising productivity, and vice versa. I think that puts meat on my argument above: if today's stronger dollar is the result of investment inflows, that in turn suggests that we will see rising productivity—and rising prosperity—in the years to come. Very good news.

Peter Navarro, Trump's trade guru, needs to look at these charts before he leads the U.S. into a trade war with China. Contrary to what he thinks (and he's most assuredly wrong on almost everything he says), China has not been keeping its currency artificially weak. As the second chart shows, the Chinese yuan has actually appreciated strongly against the currencies of its trading partners on an inflation-adjusted basis. As the first chart shows, the Chinese central bank was a huge buyer of foreign currency from 1995 through 2014 (accumulating some $4 trillion in forex reserves in the process), yet the yuan was continually appreciating over that same period. If they hadn't bought all that incoming foreign capital, the yuan would have appreciated much more than it did. Things have changed a lot in recent years, however. The Chinese central bank has sold $1 trillion of its forex reserves, yet the currency has depreciated. They been trying to prop up the yuan (by selling assets), but the yuan has nevertheless declined. The fact that their forex reserves have been relatively stable for the past several months suggests that the yuan may have found a new equilibrium. In any event, the yuan is still plenty strong, and even though the economy is only growing 6-7% these days (instead of 10%) it is still relatively impressive when you consider the meager growth of the world's developed economies.

The charts above tell a simple story: the outlook for the U.S. economy has brighter than the outlook for the Eurozone or the Japanese economy in recent years. U.S. stocks are at new highs, but the same can not be said for most other countries.

Finally, a quick look at my favorite Latin American economy, Argentina. These charts are very encouraging, since they show that by liberalizing its currency market and respecting its debts, Argentina has regained a good portion of the world's confidence that it had previously lost. Since abandoning its peso peg in December 2015, the peso on the open market has declined only marginally, even though inflation continues to hover in the 25-30% range. More importantly, the central bank has rebuilt Argentina's foreign exchange reserves dramatically over the past year. This further suggests that we ought to see declining inflation—finally—in Argentina in the years to come. Why? Because the relatively stable peso and the huge surge in Argentina's forex reserves are symptomatic of a big increase in the demand for pesos. So even though currency in circulation has expanded by almost 30% in the past year, its safe to say that the demand for those pesos has also increased significantly. And that means that rapid money growth won't be so inflationary going forward as it has been in the past.