Tuesday, November 18, 2008

Melancholy about the economy defined

Last week I got really melancholic about the economy. You all may have noticed, as this post describes my new-found economic despair. As the credit crisis persists, the risk of a longer recession grows.

Two things have changed over the last month: (1) gas got really cheap, and (2) credit conditions have worsened substantially. You see, the innate stimulus coming from cheap gas – gas that is back to early 2007 prices – will likely be outweighed by the negative effects from the ongoing fire in the credit markets.

Right now, there is a paradox in the banking system: in spite of a credit crisis the size of Jupiter, bank lending is still flowing. But new lending is not flowing (See this post and a recent Fed paper submitted by a reader here), and eventually the paradox will cease to be a paradox anymore: consumer and firm lending will dry up as existing lines of credit expire. There’s no way around it now. Look at these spreads.

The chart illustrates daily investment grade and high yield corporate spreads since 2001. The data are listed on two axes, but the relationship is clear: corporate spreads are off the charts high, and the previous 2002 peak was nothing compared to the spreads that we are seeing right now. Spreads rise during recessions, as illustrated by the circle that marks the tail-end of the 2001 recession (September 2001 to November 2001). However, the spreads reverted quickly to “normal levels” once the economy showed progress, relieving the pressure on new debt issuance and investment spending.

But today is a totally different scenario. Spreads started rising quickly in 2007 and remain at record levels in spite of the Fed's and the Treasury’s best attempt to calm credit markets. We have seen no reversion in the spreads, and the recession is just gaining ground!

Assuming that firms want access to new funds, they just can’t afford to pay the surging costs (spreads). On November 14th, the high yield corporate spread was 1590 bps (basis points, or 15.9%) above a comparable Treasury; this is almost double the 2008 to-date average of 820 bps. Furthermore, on November 14th, the investment grade spread, 558 bps, was 82% higher than its 2008 to-date average.

A closer look at 2008 re-iterates the surge in spreads since March 17 when the Fed facilitated the purchase of Bear Stearns. I remember talking to one of the fixed income managers after spreads started to descend through June 2008; he said that the Bear bailout would mark the turning point in credit markets. Oh how wrong we all were.

The longer that the credit crisis persists, the longer will these spreads remain elevated at levels that are higher than what they would have been under a “normal recession”. And there lies the new-found risk to the economy: investment, for one, is going to suffer as long as the spreads remain elevated due to the credit crisis.

Corporate spreads are off the charts, and new debt issuance is suffering greatly. With the marginal cost of issuing new debt at record levels and a full-blown recession underway, it makes sense that firms are cutting back. However, as long as the outlook on credit remains murky, these spreads have no chance of declining quickly like they did late in 2001. This brings me back to my original point: credit markets remain on red alert, which at this point, is exacerbating both the term and the depth of the recession.

Look for a sharp decline in these spreads to signal a healthier credit system.

Rebecca Wilder

4 comments:

  1. Instead of "melancholy", how about "resigned". We can control our own little world of credit/debt and consumption which may help the emotional side. The larger side is basically uncontrolled at the moment and those who could control it are in a reaction rather than action phase. Daily market swings are such an example. What is the difference if loan money comes directly from bank coffers or from the government via the bank?

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  2. "Assuming that firms want access to new funds, they just can’t afford to pay the surging costs (spreads)."

    This means that they're having to paying higher interest to lenders? People buying their bonds? And this is because the risk of default is significantly higher? People are diving in safer bonds like gov. issued? Couldn't one then work on incentives to help with this? Cutting taxes on interest say? Something?

    Don the libertarian Democrat

    PS. Is there an ETF to follow these bonds I can put on my Yahoo ticker?

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  3. Hi Don,

    Good to hear from you!

    You said, “This means that they're having to paying higher interest to lenders? People buying their bonds? And this is because the risk of default is significantly higher? People are diving in safer bonds like gov. issued? Couldn't one then work on incentives to help with this? Cutting taxes on interest say? Something?”

    The answer is yes to all. Certainly, governments could reduce corporate taxes substantially to drive down investment costs. I bet that they will (hopefully).

    The series that I use is a corporate index of a huge pool (like 3,100 new issues) of current market spreads created by Lehman Brothers (Barclays) across investment grade and below investment grade firms. This data, unfortunately, is restricted by membership. A series that is not as “good” (meaning that it is a much smaller basket), but will give you the same story as the investment grade Lehman index, is the Moody’s seasoned Baa rate at the Fed’s website: http://federalreserve.gov/releases/h15/Current/

    Take that rate and subtract off a 10yr Treasury, and you have a similar measure of corporate spreads (although the Lehman series is far superior).

    Best and thanks for your comments!

    Rebecca

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  4. Hi Janie,

    You are right – I should not be so emotional.

    You ask, “What is the difference if loan money comes directly from bank coffers or from the government via the bank?” None, and that is exactly what the Fed is trying to do – force bank lending by flushing the system with liquidity. Furthermore, consumption could stay very much the same in spite of higher saving if government spending rises by a lot.

    Thanks for reading! And thank you for your comments.

    Rebeccca

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