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Financial fundamentals are quite healthy

It's curious, to say the least, that financial market fundamentals should be relatively calm and healthy at a time when the economy faces significant risk in the form of the so-called fiscal cliff. That is not to say that all is well, however, since the consensus of the market looks for years of very slow growth.

This chart of swap spreads is one of my favorite indicators, not only of systemic risk and financial market health (the lower the spread the better), but also of the outlook for the economy. Swap spreads have a record—albeit not a very long record—of anticipating changes in the health of the economy. They rose in advance of the past three recessions, and fell in advance of the past three recoveries. Currently, swap spreads are unusually low, a sign that financial markets enjoy plenty of liquidity and there is little if any fear that conditions in the financial markets or the economy will deteriorate meaningfully in the next 2 years. In short, considering the low level of swap spreads, it would be very surprising to see the economy slip into a recession over the next year.

Bloomberg has developed a "Financial Conditions Index" which includes not only swap spreads but 14 other key indicators of financial market health. Not only has this index improved significantly over the past year, it is now at a relatively high level from an historical perspective. Nothing here would suggest any deterioration in the financial market fundamentals. When financial market fundamentals are as healthy as they are today, that points to a very low probability of any meaningful deterioration in the economy.

Yet despite all the encouraging signs of financial market health, the extremely low level of real yields on TIPS suggests that the market believes that the economy is likely to be relatively stagnant over the next several years. Nominal yields on Treasuries are at rock-bottom lows as well, and both nominal and real yields are consistent with a view that the Fed will keep interest rates near zero for the foreseeable future. That, in turn, will only happen if the economy continues to struggle, and continues to suffer from a significant "output gap."

Ordinarily, the extremely low level of nominal yields that exist today would be a sign of very low inflation or even deflation. Yet as this chart shows, the expected inflation rate for the next 5 years that is embedded in TIPS and Treasury prices is more or less "normal." Expected inflation according to the Treasury market is 2.1% per year for the next 5 years, and 2.9% for the subsequent 5 years, and that is not at all out of the ordinary compared to the past 15 years. So very low real and nominal yields say nothing unusual about inflation; instead they shout out a very dismal outlook for the economy.

Consumer confidence has increased over the past year, and now stands at a post-recession high according to the University of Michigan's survey. While this is encouraging, the level of confidence is still relatively low from an historical perspective, and only slightly better than the levels we saw during the tumultuous years of the early 1980s. As I see it, consumers are saying that although we have pulled back from the abyss, the outlook remains bleak.

Healthy financial fundamentals, but miserable expectations for economic growth: quite an unusual combination that can only mean that the market is braced for a lot of bad news, as I've been arguing for a long time.

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