JRE - Swap And Credit Spreads Say No Recession

2023-03-10 07:47:00 ET

Summary

• Aggressive Fed tightening over the past year or so has devastated the value of bond portfolios because interest rates have risen by more and faster than during any prior bond bear market.
• The bond market is signaling that the outlook for the economy is generally healthy, and liquidity conditions are good.
• Higher interest rates are having a big impact on asset markets, which in turn implies that Fed tightening is working.

Today the market was rattled by news that Silicon Valley Bank (SIVB) was forced to sell most of its bond portfolio at a nearly $2 billion loss and will now have to raise additional capital to remain solvent. The question on everyone's mind: is this the first inning in a replay of 2008's financial crisis? Aggressive Fed tightening over the past year or so has devastated the value of bond portfolios because interest rates have risen by more and faster than during any prior bond bear market. To make matters worse, Chairman Powell two days ago declared that the Fed may well have to raise rates by even more than they expected, in large part because the economy is proving stronger than expected.

So what is it? Will the SIVB collapse mark the beginning of another financial crisis which in turn triggers the long-awaited recession? Or is the economy so healthy that the Fed will need to raise rates even more? Inquiring minds would like to know how these two fears can coexist.

I don't pretend to know the answer, but I do know that—outside of the now-famous inverted yield curve—it's difficult to find any signs that a recession is around the corner. A big disappointment in tomorrow's jobs number might persuade me to become less complacent, however.I also know that, thanks to the decline in M2 and today's much higher interest rates, inflation pressures peaked some months ago and inflation is quite likely to decline over the course of this year as it returns to the Fed's 2% target. Following are some charts that round out the story:

Chart #1

Chart #1 shows the level of 2-yr swap spreads in the U.S. and Europe. These spreads have an uncanny ability to predict the onset and end of recessions (higher spreads predict bad news for the economy, and lower spreads predict better news). Eurozone swap spreads are still elevated, but they have come down significantly in recent months—thank goodness. U.S. swap spreads are only modestly elevated (a "normal" range would be roughly 15 to 35 bps) and they too have been declining of late. No signs of a recession here.

Chart #2

Chart #2 shows the level of corporate credit spreads. Like swap spreads, these too tend to predict the beginning and end of recessions. Current levels reflect substantially "normal" conditions. The bond market is signaling that the outlook for the economy is generally healthy, and liquidity conditions are good. No signs of a recession here.

Chart #3

Chart #3 is another way of looking at the spreads in Chart #2: the line represents the difference between high-yield and investment-grade spreads, otherwise known as the "junk spread." Here it becomes perhaps clearer that conditions today are pretty normal.

Chart #4

Chart #5

Charts #4 and #5 focus on Credit Default Swap Spreads, which are highly liquid and quite representative of generic credit risk. Here too it's difficult to see signs of distress.

Chart #6

Chart #6 shows the level of 30-yr fixed mortgage rates. Never before have they risen so much in so short a time. This has caused profound distress in the nation's real estate market. Real estate is the one area of the economy that is really suffering, but as the previous charts suggest, this suffering has not been contagious to the broader economy. One positive thing to note is that there is not a large overhang of new construction or a significant inventory of homes for sale (like we had in 2005-2006). The solution to the current real estate problem is not a collapse but a repricing: housing prices went up too far given the simultaneous surge in financing costs. The solution is simple, but it may take awhile to play out: prices need to fall and interest rates need to decline.

There is one good thing to note here: higher interest rates are having a big impact on asset markets, which in turn implies that Fed tightening is working. The Fed doesn't need to do much more, if anything.

Chart #7

Changing the subject, Chart #7 shows a very important macro statistic that is generally ignored by the financial press. Households' real net worth fell by about 9% last year, but it is not out of line with historical experience. As the green line suggests, this measure of our nation's well being has improved by about 3.6% per year for many decades, and the current level of real net worth is right in line with the long-term trend: $148 trillion.

Chart #8

Chart #8 is remarkable in that the jobs market is apparently more healthy today than it has been in a long time. Job openings are near record highs, and they exceed the number of people looking for work by a record margin. Some employers are shedding workers (e.g., the tech sector), but most others are having difficulty finding people willing and able to work. This is not the sort of situation that precedes recessions.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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