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Swap spread update

Swap spreads continue to be excellent, market-based, forward-looking indicators of financial and economic troubles ahead. The swap market is highly liquid, and spreads are a very good indicator not only of counterparty risk (typically large banks) but also of systemic risk. When swap spreads rise above their "normal" range of 25-35 bps, then that means there are some real problems brewing in the economy.

Today, U.S. 2-yr swap spreads are only 33 bps, and they have been within a normal range throughout the current business cycle expansion. They are telling us that financial markets are healthy and enjoy sufficient liquidity, and this is consistent with an economy that is growing, however slowly. There are no hidden surprises out there just waiting to ambush us. Spreads have picked up a little this year, but that can be traced to worries about the health of European financial markets, where 2-yr swap spreads are almost 100 bps. Europe has a problem—the very real threat of sovereign debt defaults—but we don't have anything like that.

Another market-based indicator of risk is the yield on junk bonds; the higher the yield, the weaker the economy and the higher the risk that leveraged borrowers might default. Junk bond yields now average 8.4%, according to Bloomberg, 30 bps lower than their average since the current recovery began, and only 20 bps higher than their average since the beginning of last year. Junk yields are 210 bps lower today than they were at the onset of the 2008-09 recession.

Taken together, these two indicators are not even close to signaling a double-dip recession.

And did I mention that corporate profits are at all-time nominal, real, and GDP-relative highs? Businesses have fired lots of people and become lean and mean and profitable. Where is the impetus for another round of huge cutbacks of the size necessary to ambush overall growth?

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