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.