This week we provided the following posts for our newsletter subscribers:
- 6 Reasons why Labor will win the next Australian election;
- Lessons from Toronto’s housing market correction;
- How Credit Spreads give us key insight into the bullish story;
- Why government are the problem – not the solution to economic growth;
- What the market thinks of “fire and fury”; and
- An analysis of the S&P 500 – highlighting key support levels in the event of a correction
Provided below is a copy of the newsletter released on August 8th “How Credit Spreads give us key insight into the bullish story”
Long-term readers will know I remain steadfastly bullish on the US market.
There’s plenty of solid reasons to be optimistic.
But as readers will also recognise – my focus is always on what is happening – and not what might happen.
There’s a massive difference.
Too many traders fall victim to the latter (this missive is another example). Price is the ultimate truth – the rest is merely opinion.
Which brings me to the headline I saw on CNBC today:
Wow, there are just three pillars holding this whole thing together!
Well, one must be credit – I wonder what the other two are?
With respect to the market’s oxygen – I know credit (and liquidity) are in abundance… which I will prove shortly.
But the other two pillars must be in bad shape. In any case, “crumbling” sounds more like what we saw in 2008 don’t you think?
Things were certainly crumbling then – as credit default swap spreads went through the roof and safety came at a large premium.
But here’s the thing:
Yes there are problems. There will always be problems.
Stocks will continue to climb the “wall of worry”.
And whether that’s monetary policy tightening or what Trump is tweeting about the “fire and fury” with North Korea; or whether China is coming to a grinding halt – problems will persist.
But does that mean we trade on what might happen?
Today we provide (another) valuable lesson.
We assess what investors (who have trillions tied up opposite debt instruments) think about the market “crumbling”.
And I will show what they are prepared to pay for risk premiums above and beyond risk-free Treasury yields (and it’s not much).
But first some background…
As a preface, this missive is a good one to bookmark for future reference.
It’s to do with credit default spreads… a great barometer for assessing risk and the market’s general health.
For those new to the newsletter (and there have been quick a few since I have stopped posting to the website each day) — credit spreads represent the extra amount of yield that investors demand to hold debt that is riskier than US Treasuries.
In plain english – swaps are transactions that allow people to redistribute risk.
They are over the counter agreements between any two parties to exchange one cash flow for another.
The most basic swap is fixed rate for floating rate payments.
For example, let’s say I own some bonds (ie fixed rate instruments) but I worry about the prospect of interest rates rising.
This is a problem for a bond investor as the capital value of their investment will fall.
What can investors do in this scenario?
I might want to reduce my (fixed rate) exposure by entering into a swap with someone else.
That is, I would pay him (or her) the fixed rate I receive on my bonds and he would pay me a floating rate, typically Libor. That way I have hedged my position for any downside.
I reduce my risk that way, and he increases his.
He also becomes exposed to the risk that if interest rates fall, I might renege on my promise to pay him a fixed rate and he might lose out on the profit inherent in his position.
In order to compensate him for these risks I need to pay him the fixed rate plus a little extra, which is the swap spread: the difference between the rate I am paying him and the rate on a Treasury bond with a maturity equal to the term of the swap agreement.
So swap spreads are a lot like credit spreads since there is counterparty risk involved.
The short version is these are a great barometer of risk aversion in the marketplace.
Put another way, the more people want to swap out of their risky exposures, the more they must be willing to pay to induce others to accept that risk.
Rising swap spreads equate to more risk aversion. Swap spreads can be thought of as barometers of systemic risk for the same reason.
To measure these – swap spreads during normal times and normal markets typically trade in the range of 30-40 basis points.
What Do We Find Today?
In short, investors are comfortable with economic conditions (despite the ‘noise’ we hear in mainstream).
That is, credit spreads are uniformly low.
This tells me that liquidity in the bond market (the market’s oxygen) is abundant. And that’s critical when it comes to risk assets (eg stocks).
Take a look at this chart for two-year swap spreads:
One way of interpreting this is it’s a great sign that systemic risk of default is low — and in turn — the general outlook for corporate profits (and the economy) is healthy.
Now once I see these spreads start to widen – and the premium paid is high opposite Treasuries – then I will start to wave my “stocks are crumbling” flag (as I did in 2007 and 2006).
The green-zone is where we like to be; ie below 40 basis points.
Today we sit comfortably around 25 basis points… ie normal.
What it also tells me is the Fed “tightening” of the past 12 months (and telegraphed reduction in their balance sheet) has not created a shortage of money (which is what our friends at BAML are fearful of).
If anything, BAML are committing one of the most basic trading mistakes.
That is, they are trading on what they might think happen… versus what is happening.
However, if they are proved correct – and we see a shortage of money – yes – it’s time to get worried.
These are the conditions we will see in the lead up to every recession. But they are not present today.
As another proxy – take a look at what we see with corporate spreads.
Below is BAML’s own US Corporate BBB Option-Adjusted Spread (from the Fed Reserve):
Again, spreads are relatively low, as you would expect them to be in a healthy, growing economy.
And whilst they are not record lows – there is nothing here which screams investors are paying excessive premiums in the event of company default risk.
Putting it All Together…
Ahhh the wall of worry.
Not a day goes by where there isn’t some headline about some perceived (or probable) risk.
My tip: focus on the data and what is happening.
Here’s a statistic for you:
There are something like $6.3 trillion of investment grade bonds and $1.3 trillion of high-yield (junk) bonds current on issue in the market.
Today both spreads on quality and high-yield debt are relatively low.
However, when times turn and things are “crumbling” – yields on these instruments will spike. We have seen this in the past well before things got really rough.
The reason they are low today is this is what you would expect in a growing economy when credit and liquidity is not at risk.
… trade the tape
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