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Corporate bond valuation update


This chart shows spreads on 5-yr credit default swaps, for investment grade and high yield corporate bonds. Spreads have surged since July, and are now back to levels that preceded and foreshadowed the onset of the worst of the Great Recession. Is this a sure sign that we are on the cusp of another recession? As much as I think spreads are excellent and forward-looking indicators of economic and financial market fundamentals, I don't think this chart shows the whole story.


This second chart compares 2-yr swap spreads to junk bond yields. Swap spreads are excellent and forward-looking indicators of systemic risk; today they are in the upper range of the levels (15-35 bps) that typically prevail when the economy is navigating relatively stable seas. Swaps did an excellent job of predicting the collapse of the junk bond market in 2008, and an excellent job of leading the huge rally that began in late 2008 and continued through last year. Today, swap spreads are signaling only mild upper pressure on junk yields—nothing to get very excited about.

So why are spreads on corporate debt (top chart) so high? It's mainly because the yields on Treasury debt are extraordinarily, incredibly low. The European sovereign debt crisis has created gigantic demand for Treasury debt, greatly depressing yields in the process. The big widening of corporate debt spreads is only partly due to a deterioration in the prospects for U.S. companies, and mostly due to the desperation that is gripping European investors.

Equity valuation update



This week's market swoon improved equity market valuations that were already attractive. The 12-mo. trailing PE of the S&P 500, according to Bloomberg, is now around 12.5, well below its 50-yr average of 16.6. On an earnings basis, equities are now yielding around 8%, much higher than the 5% yield on BAA corporate bonds, according to Moody's.

The only logical explanation for why valuations are so attractive is that the market fully expects a significant deterioration in corporate earnings in the years to come. Again, my point is that the market is priced to some very pessimistic assumptions. If things don't turn out to be as bad as the market now expects, then there is plenty of upside left in the stock market.

What was missing in tonight's Republican debate

The Republican candidates for president are doing a good job of honing their anti-Obama and pro-growth, pro-jobs arguments. The election is shaping up to be epic because the choices couldn't be more stark or fundamental, and the outcome will undoubtedly have a profound impact on the future of the U.S. economy.

Obama has defined the liberal position in no uncertain terms: There is no way we can make any significant cuts in current and projected spending; to close the deficit we will need more taxes, and only the rich can afford to play that role. Meanwhile, we can grow the economy by giving the government more opportunities to direct the course of the economy.

The Republicans are making the exact opposite point: There is no way we can allow the government to remain as big as it is (close to a post-war high relative to GDP), and there is no way we can impose higher tax rates on this economy; to close the deficit we will need to reduce the size and role of government. We can grow the economy by relying less on government to make decisions for us, and more on individuals and free markets to make the right choices.

If you believe that government can administer the economy's scarce resources better than the private sector, vote Democrat. If you believe the private sector administers those scarce resources better than government bureaucrats, vote Republican.

So far, so good, but the Republicans are making three huge mistakes.

The biggest mistake the Republicans are making is on the subject of immigration. The party is veering far too much in the direction of isolationism, and the party is much too anti-immigrant for my taste.

This country was built by immigrants. I believe the vast majority of immigrants are people who are willing to risk everything in the hopes of creating a better life for themselves and their family in a place they've never been. Immigrants bring new blood into the country, new ambition, and yes, they compete with legal residents for jobs. But prosperity is not a zero-sum game. We can have more immigration and more jobs for everyone, if we have the right fiscal and monetary policies and if government gets out of the way of the private sector.

Why do we have so many illegal immigrants? So far, the only answer I've heard is that the federal government has failed to secure our borders. We have failed to keep out the people who desperately want to get in, to find work, and to improve their lives. So, according to most of the candidates, we need to build a bigger fence and devote more resources to policing the border.

I haven't heard anyone say that maybe we unwittingly have created huge, perverse incentives for immigrants to come, because we have a huge social safety net that is not too hard for anyone (including legal residents) to game. Build it and they will come; offer generous handouts and subsidies, and don't be surprised if all sorts of legal and illegal people sign up for a piece of the action.

I haven't heard anyone say that maybe we have so many illegal immigrants because we are making it extremely difficult for those who want to come here, to come legally. We have an immigrant quota system of roughly 500,000 per year, but many more than that want to come. I personally know several people who have waited 5 to 10 years to get a resident visa, because the countries they came from had huge waiting lists. Would you be willing to wait 10 years to take your family to America if you were suffering and willing to work hard?

One solution to our immigration problem would be to drastically increase our annual quotas, especially for those who are offered a job here by an existing business. As it is, work visas are extremely limited in number, and are often allotted in a matter of days, leaving businesses who want to hire a foreigner (perhaps one educated at our excellent universities) in the lurch for the rest of the year.

Another solution to the immigration problem would be to reduce the size of our social safety net. Fewer handouts and fewer subsidies would reduce the incentive to come for those who just want to take advantage of our generosity. Why not tell today's immigrants what we told the massive waves of immigrants who came here around the turn of the century? Don't come here looking for a handout; you'd better have someone willing to sponsor you if you can't take care of yourself; and be sure to learn English as fast as you can so you can be a productive member of society.

In dollars and sense terms, a significant expansion of legal immigration is simply in our nation's best interest. That's because without immigrants, the U.S. population will soon start to shrink just as the populations of Europe, Russia, and Japan are now shrinking. Without an ever-growing population, we have no hope of delivering on today's social security and medicare promises. If we shut the door on immigrants we will be cutting off our own nose to spite our face.

The second biggest mistake the Republicans are making is with social issues.

Libertarians are the conscience of the Republican Party, and libertarian philosophy tells us that the government that governs the least is the best. Why, if Republicans are all for individual freedom and free markets, are they also calling for national rules governing abortion and gay marriage? Why should the government give me free rein when it comes to working, but stick its nose in my bedroom?

The only sensible approach to social issues is this: they are not within the purview of the federal government. Perhaps they are issues best left to the states, or perhaps they are simply matters of conscience and morality. Personally, I am against abortion, but I'm understanding of the girl who was raped and can't abide the thought of having a baby whose father violated her. Regardless, I don't see why the federal government has a say in the matter or why federal money should be used to fund her abortion.

The third issue that is entirely missing from the debates so far is this: Should the federal government undertake works of charity? Liberals love to feel compassion for the downtrodden and the unfortunate, but when they create government programs to take care of these people, they are doing charitable works with other people's money. That's not charity, that's theft, and it's immoral. Charity is using one's own money to help the downtrodden and the unfortunate. Americans are famously charitable, and I'm convinced that there is no shortage of charitable funds in this country to deal with those who have truly suffered from bad luck or bad genes. There would be even more money available for private charity if we cancelled a good portion of the transfer payments that today represent well over half of total federal spending. Charity should be in the exclusive purview of individuals and the private sector.

In this same vein, it makes no sense for the federal government to design and administer a national healthcare system: that is better left to the private sector. A few simple changes would do wonders toward reforming healthcare: change the tax code to eliminate the huge incentive for employers to pay for employees' insurance, since that will give individuals responsibility for their own healthcare decisions; change the rules to allow insurance companies to offer policies across state lines; and stop governments at all levels from mandating levels and types of coverage. In general, anything that decentralizes decision making, gives individuals the responsibility for paying for their own healthcare costs, and opens the door to competition and market-based innovation is a good idea.

Finally, not only is government "charity" immoral (because it appropriates one person's money to pay for another person's idea of what is right), it is inefficient and destructive of the very fabric of society. When the government tries to take care of our every misfortune, we cease taking responsibility for ourselves and our loved ones. As Milton Friedman taught us years ago, you spend your own money on yourself much more carefully and thoughtfully than you would spend other people's money on other people. We need to get the incentives right, because today they are all screwed up.

It's still all about Europe

The market's wild reaction to the FOMC's announcement yesterday (gold down, dollar up, euro down, T-note and T-bond yields down, equities down, commodities down) begs an attempt to diagnose what is going on. One explanation that seems to make sense is that what the market was really looking for from the FOMC was a QE3, not an Operation Twist 2. Increasing the duration of the Fed's Treasury holdings doesn't do much of anything for the economy, but deciding to no longer pay interest on excess reserves, for example, would have been a clear move to an easier policy stance, and that might have relieved some of the pressures in Europe, or at least so the thinking goes. By not announcing a true easing of monetary policy, the FOMC's announcement could thus have sparked fears that the deterioration in Europe was increasingly likely to result in some sort of economic destruction. 

So here's my guess as to mindset behind the market moves these past several days: The market's desire for Treasury bonds has gone way up because there is huge demand for a safe asset that still pays interest and is assured of having a buyer for the next 10 months. Plus, as indicated in my previous post, the mortgage market's negative convexity is adding significantly to the market's desire for duration, thus accentuating the decline in Treasury yields. The demand for euros fell because Europe is now seen to be in worse trouble—not even the Fed can help, and the dollar is the only safe-haven that is still cheap. Gold wasn't favored because if the Eurozone economy collapses, then inflation is more likely to go down than up (recall that gold fell in the second half of 2008); this message is also seen in the 30 bps drop in forward breakeven inflation spreads since last week.

Equities everywhere are down because the market fears that a Greek default is imminent and it will be contagious and that could result in a global financial crisis and/or a global economic slump similar to what followed in the wake of the Lehman collapse in 2008. Commodities are down because of the widespread fear that a global economic slump/collapse is just around the corner, and because speculators everywhere have been burned by huge volatility.

At the core of all these concerns is Eurozone sovereign debt default risk, as I noted here and here

To balance these fears, and to flesh out some of the price action, consider the following updated charts:


Since late 2009, the number of U.S. persons receiving unemployment insurance (above chart) has dropped by 5.2 million, or more than half (i.e., down 55% from a peak of 11.5 million). Over this same period, the unemployment rate has declined from 10.1% in Oct. '09 to 9.1% today.  Fewer people being supported by unemployment insurance equals more people with a greater incentive to find and accept a job. In the end, that is a good thing.


Over that same time frame, the number of new claims for unemployment insurance has been falling steadily. On an unadjusted basis (see chart above), new claims were only 350K in the week ending Sept 16th, down from 382K in the same week last year. There is no sign here of any imminent or emerging collapse in the U.S. economy or the jobs market.


On a seasonally-adjusted and smoothed basis, the trend in weekly claims appears to still be declining. Recessions are always preceded by a substantial increase in claims, but that is manifestly not the case today.


The index of Leading Indicators continues to rise, up 6.5% over the past year. Every recession for the past 50 years has been preceded by a significant decline in the growth rate of this index; that is not the case today. To be sure, this index is not always a good leading indicator, but it is not even close to signaling impending doom or even a modest recession.


The behavior of swap spreads—excellent leading indicators of systemic risk—is the clearest indicator that it is Europe that is facing the big problems. There is now a huge and unprecedented divergence between U.S. and Eurozone swap spreads. Systemic risk in the U.S. remains within a "normal" range, but eurozone swap spreads are over 100 bps, a sure sign of imminent and painful problems there.


The dollar has been the main beneficiary of the recent panic crisis, but it is still quite low from an historical perspective. It's recent strength derives mainly from the new-found weakness in the euro, not from any effective tightening on the part of the Fed. Maybe a QE3 could have helped Europe, but that is far from obvious, and in any event there are no other signs that dollars are in short supply relative to demand.


The most recent data on residential and commercial property prices (June and July, respectively) shows that prices have been roughly flat for the past two and a half years. The bursting of the commercial property price "bubble" is quite obvious here, but now that it has burst, prices are no longer declining.


The recent plunge in copper prices is typical of many commodities: very painful, but not by any means unprecedented, and prices are still quite elevated from an historical perspective. Speculators of all stripes have been burned in many ways with all the volatility sweeping the markets these days. It's not surprising that commodity prices have corrected.


Gold has suffered a nasty, $180 decline from its recent, all-time high, but from a long-term perspective it looks like a simple correction. Gold only got as high as it is because it has been pricing in lots of devastating news; this recent decline could be an indication that although the recent news has sparked a panic in bond and equity markets, it's not as bad as gold investors had expected.


To date, the drop in the S&P 500 from its recent highs has been about 15%. Prices are still almost 70% above the Mar. '09 lows. It's a panic, to be sure, but not nearly a collapse. Corporate profits have doubled from their year-end 2008 lows, the average PE ratio is only 12.3, according to my Bloomberg, and those facts provide a strong safety net for prices.

Taking everything into consideration, it's quite apparent that the source of the recent angst is the increasing likelihood of a major sovereign default (e.g., Greece), and the fear that this might prove contagious and eventually escalate to the level of a global financial and economic panic. There's no denying that Greece is almost certainly going to default, and that it will be the biggest sovereign default on record. Whether that is big enough to bring down the entire world is the question at hand. I just don't see it.

Mortgage market panic adds to market distortions


10-yr Treasury yields have never been as low as they are today (1.73% as of this writing). Meanwhile, the effective duration of the MBS market has rarely been lower. The two go hand in hand, since the huge collapse in the duration of MBS (from a high of 4.9 years last April to just 1.5 today, by my estimates) has forced large institutional money managers to buy huge amounts of Treasury notes and bonds in order to keep the duration of their portfolios from collapsing, otherwise they would suffer significant underperformance. Declining MBS duration, in other words, has contributed significantly to the decline in Treasury yields.

The combination today of record-low Treasury yields and almost-record-low MBS duration is like compressing a massive spring: if and when the downward pressure on yields lets up, we will see a massive rebound in yields as the recent process reverses. Managers would be forced to sell massive amounts of Treasury notes and bonds in order to offset the huge increases in MBS duration that will follow any rise in Treasury yields. Thus it is that the mortgage market, which comprises about 28% of the investment grade U.S. bond market, can sometimes be the tail that wags the much larger dog—magnifying greatly the market's underlying volatility during periods of stress. Just a modest nudge from the Fed, in the form of the upcoming Operation Twist, can result—at least temporarily—in a huge decline in yields. And just a whiff of good news could send yields sharply higher. We have seen big reversals before when similar conditions existed (i.e., a big decline in 10-yr yields and a big drop in MBS duration): last Fall, early 2009, the Summer of 2003, and early 1999. The next one could be the mother of all Treasury meltdowns.

The only way that a big increase in yields can be avoided is if the downward pressure on Treasury yields continues. And that can only happen if the economy enters another profound recession, and/or inflation turns negative. Once again we find ourselves on the edge of the same abyss we were staring into at the end of 2008: this market is priced to something akin to the-end-of-the-world-as-we-know-it; nothing less than a catastrophic deterioration from current conditions. No one can rule out a truly worst-case scenario, but to get there requires a whole host of things to go from today's unpleasant to absolutely abysmal. I'm not prepared to bet that the bottom will fall out of everything, so that leaves me bullish compared to where the market is.

Rents vs. housing prices


I've seen a lot of talk lately about how the CPI is way over-stating inflation, since its largest component—owner's equivalent rent—has increased over 7% since the end of 2006. Housing has contributed to inflation? How can that be if we all know that home prices have collapsed. Ha, ha.

The chart above helps to understand what is really going on. Due to the extreme volatility of housing prices in the 1970s, in the BLS decided in the early 1980s to switch from using home prices as an input to the CPI to instead using "rents," since they don't tend to change as much. This decision remains controversial, but as the chart shows, rents (which are estimated) have been much more stable than prices, and over time the two have tracked pretty well. If the CPI is overstating inflation today because it uses rents instead of prices, then it was hugely understating inflation in the late 1990s and early 2000s. Regardless of whether you had used housing prices as an input to the CPI, or rents, by now the cumulative amount of inflation you get is roughly the same. The difference between prices and rents evens out over time, which stands to reason.

This chart uses all the available data from Case Shiller, and that data only includes the prices of the 10 largest metropolitan markets, so the fact that prices have increased about 16% more than rents since 1987 is not to be given too much importance. The important thing is to see how the two series track each other over time. It's my understanding that rents today (which are widely reported to be rising) are becoming expensive relative to the cost of purchasing a house. So an ideal version of this chart might show that owner's equivalent rents have risen more than housing prices over the past several decades. But in any case, it disproves the allegation that the BLS is mis-reporting inflation. Rents and housing prices have come back into line, after a period in which housing prices were grossly inflated.

Operation Twist is over-hyped


With 10-yr Treasury yields trading at historic, record lows, we need lower yields to stimulate the economy?

As we wait to hear from the FOMC regarding whether they will embrace the much-hyped Operation Twist strategy, I have to believe that the market will be disappointed. For my money, 10-yr yields are as low as they need to go already. Either the Fed will not embark on a new "twist" strategy, or they will do it in a very modest fashion to show that they are concerned about the economy, but it won't make much, if any difference, to the monetary policy fundamentals.

UPDATE: The FOMC announced a shift in its existing holdings which involves the sale of $400 billion of securities of 5 years maturity and less, coupled with the purchase of $400 billion of securities with maturities of 6 to 30 years, and a decision to reinvest principal payments from existing MBS in new MBS. Thus there will be no material expansion of the Fed's balance sheet. This leaves the major thrust of monetary policy intact, while fiddling around the edges with the yield curve. Given the existing extremely low level of longer-term Treasury yields, I don't see that this policy announcement will have much impact on the overall health of the financial market or the economy.

Mortgage, housing update



August housing starts were somewhat weaker than expected (571K vs. 590K), but building permits (which point to future housing starts were a bit stronger than expected (620K vs. 590K), so on balance there's no news here. The larger story is told in the charts above. Housing starts have been bouncing along the bottom of their worst nightmare collapse, and this has been going on for over two and a half years. One chapter of the big story is that housing starts have hit bottom; if they were going to go lower, they would have done so by now. The other chapter is that housing starts are going to have to increase by leaps and bounds over the next several years, if only just to catch up to the demands of a growing population.

The longer starts remain at current levels, in fact, the higher the probability that we could be experiencing a general housing shortage within a few years, since the rate of family formations is running well above the current level of starts. That future housing shortage might collide with an abundance of money (if the Fed is slow to mop up the massive amounts of excess bank reserves it has created) to produce another major rise in housing prices. We can't know the timing of the next upturn in the housing cycle, but increasingly, the question is not whether housing prices will rise, but by how much.


When you can borrow at historically low, long-term fixed rates of 4-4.5% to buy into what could be an impressive runup in housing prices, it matters little whether prices have reached their lows or whether they might drift somewhat lower before heading higher.

No need for Operation Twist

Those who look for another Operation Twist are likely to be disappointed, because today's problems have nothing to do with the shape of the Treasury yield curve.  

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3-mo. T-bill yields are zero, and gold is trading close to all-time highs in both nominal and real terms. These are classic signs that the world has an intense desire for safety.


10-yr Treasury yields of 1.9% reflect the market's belief that the outlook for U.S. growth is dismal if not downright depressing. It is also likely that 10- and 30-yr yields have been depressed of late because the market believes that another round of quantitative easing and/or an "Operation Twist" (in which the Fed would step up its purchases of longer-term Treasuries and/or lengthen the duration of its Treasury holdings, in order to reduce long-term yields and thus stimulate the economy) is imminent; i.e., the market is "front-running" expected Fed purchases.


Very pessimistic growth expectations and strong Operation Twist expectations have combined to flatten the yield curve by almost 100 bps since July. But the curve is still about as steep as it has ever been in the early years of previous business cycle expansions. A steep yield curve has never been an obstacle to growth before—indeed, recessions almost always follow very flat or inverted curves—so why should Operation Twist be so urgent or necessary? As Bond Girl notes, "The duration of the Fed’s portfolio is not what is standing between us and economic prosperity."


Despite the intense level of concern, U.S. swap spreads are still in what is considered to be a "normal" range, suggesting there is very little systemic risk in the U.S., and that financial markets are reasonably liquid and healthy. Eurozone swap spreads, in contrast, are quite elevated, reflecting fears that an imminent Greek default could prove contagious and ultimately bring down the European banking system and perhaps the Eurozone economy as well. Again, the risks confronting the U.S. economy today are primarily of European origin.


The very obvious problems plaguing the Eurozone have resulted in a significant decline in Eurozone equities, bringing them back down almost to their March 2009 panic lows. In contrast, U.S. equities have only been moderately affected.


As the above chart shows, the decline in long-term yields (white line) has been highly correlated to the collapse of Eurozone equities.

All of this suggests that a further flattening of the yield curve—assuming that Operation Twist is even capable of further depressing long-term yields—is unlikely to make much of a difference to the U.S. economy. The level of long-term yields, which are already historically low, is all about threats to growth; long-term yields are not an obstacle to growth, they are the result of expectations that growth will falter. Lower rates are not going to improve the outlook. Mortgage rates, now at historic lows, are not stimulating the economy, because they are symptomatic of an economy that is weak.

If the outlook for growth improves—whether as a result of Operation Twist, or the reduced risk of a European collapse—then long-term yields are almost certain to rise. Which is another way of saying that Operation Twist can't ever do what its advocates believe; any actions on the part of the Fed which end up materially improving the outlook for growth will raise long-term interest rates, not depress them. Operation Twist could only be successful if long-term interest rates rise.

I would like to believe that the Fed understands that there are limits to its ability to make a difference at this juncture. Plus, more market intervention, in the form or an Operation Twist, would only muddy the waters; a less activist Fed would reduce the level of uncertainty and risk that is plaguing markets today. If the FOMC meeting this week fails to deliver an Operation Twist, I for one would be relieved. It's not the fix for what ails the economy.