Chop to the Top

Chop to the top.  In a choppy day of trade equities ended up in the positive with a little help from an Administration advisor and no surprises from Fed speakers.  As reported yesterday morning, President Trump not only stated that he would allow the second set of tariffs to kick in on Jan. 1, but also talked about another new round of tariffs which would include consumer electronics (AKA Apple).  As one might expect markets traded off on the news.  Then came a flurry of Fed speakers all of which had their own unique way of saying… well, nothing really.  To sum it up, the Fed’s moves will be data dependent, that means that they will look at the data and make a decision based on the economic numbers.  We should be thankful for that.  There is also a raging debate about how close we are to the so-called neutral rate in which inflation is under control and the economy is able to continue to grow and it appears that all of the governors think that we are close if not already there.  This makes their jobs in the upcoming meetings more challenging, but alas they can always decide what to do based on the data.  Traders were please not to have heard any new scary information helping stocks come off their early lows.  It is probably not news that the President is unhappy that the markets have had a rough year and is doing and saying everything he can to either move them up or blame others for their underperformance.  His latest target is Fed Chairman Jerome Powell with whom he is not pleased.  According to the President, it is Powell’s fault that the markets are flat to down on the year and that he should not raise rates but actually lower them. Ok.  Now on to that whole trade thing, which probably has a bit to do with GM announcing plant closures, product retirements, and massive layoffs.  The reasons cited by the company include slowing sales, increased costs from rising wages, rising costs of raw materials (steel and aluminum), and increased costs of components.  Later in the session, Larry Kudlow, top economic advisor, cheerleader, and a member of the plunge protection team was sent out to make traders feel good about the prospects of a trade deal.  He really said nothing new but he was successful in making traders feel good and in sending a televised message to the Chinese that out economy is stronger than theirs.  Markets traded up after the press conference.  Thanks Larry.  The President will be meeting with Chinese Leader Xi Jingping at the G20 summit which commences tomorrow evening.  If they can come up with a compromise, prospects for equity markets will go up significantly regardless of all the cheerleading and jawboning.  Finally, hidden in between all of the Fed and Administration speaking yesterday, the treasury auctioned 5 year notes amidst lots of growing talk about a credit bubble.  Spreads on corporate bonds have been increasing lately indicating that traders sense risk ahead, and when that happens the bond bubble debate usually heats up.  Because it is geek-out Wednesday I thought we might delve a bit more into the bond bubble discussion.  Warning – reading this may require some coffee.

First, let’s talk about spreads.  All agency, corporate, and municipal bonds are generally priced based on yield spread to US Treasuries. If a trader wants to have an idea of what a bond’s price should be, they would start by getting the yield to maturity (YTM) of a US Treasury with a similar maturity, add a spread, and then use the new yield to come up with a price.  The additional yield the investor gets by adding the spread is a risk premium, which the investor is paid for taking the risk.  Treasuries are used as a baseline because they are considered to be risk-less.  In other words, the US Government would sooner raise taxes, borrow more money, or print money before they would ever default.  Those tools are not available to corporations and they would be forced to default if cash were not available to service their debt. Ratings agencies such as Moody’s and S&P rate bonds based on their issuer’s ability to pay for the specific note.  Lower rated bonds have greater risks and wider spreads which means that investors are paid more to take on the larger risk.   If treasury markets go up, yields go down and corporate YTM’s go down by the same amount causing their prices to go up as well.  Seems straight forward right?  Of course not.  The catch is that spreads are not set in stone.  They will increase if the issuing company is perceived to be performing poorly.  The increase in spread is compensation for the increased risk.  Likewise, if a rating agency lowers a credit rating or puts the company on credit watch (almost the worst case scenario for bond holders) spreads will also increase.  By the way, the opposite is true when things are going well causing spreads to tighten.  By now, if you are still following me you will realize that spreads on bonds are a good indicator of perceived risk.  When they are tightening, prospects look good and when they are widening investors are worried about the future.  If you look at the bottom panel of the Fixed Income Cheat Sheet on page 17 of my attached daily chartbook, you will see that I display the recent history of corporate bond spreads.  You will note that the lowest line (olive color) are investment grade bonds and the highest line (light blue color) are CCC high yield (AKA Junk) bonds.  So far this is consistent with our discussion – bigger spreads for bigger risk.  Now you should note that all spreads have been rising.  Why?  Because of perceived risk ahead.  To put a finer point on it, BB (which is one rating below investment grade) corporate bond spreads were +2.16% a year ago and they are at +2.80% today (see attached chart). Likewise, AAA corporate bond spreads were +0.58% a year ago and +0.65 % today (see attached chart). Spreads are wider, but by less, as one might expect healthier companies to be able to weather bumps in the road.  Ok, so now on to the bubble.  Let’s start with total Federal Debt.  Just before the financial crisis, total federal debt was $8.86 trillion, which seems like a lot.  Today that number has grown to $21.2 trillion (see attached chart).  That’s a lot. Now let’s look at outstanding corporate debt.  Non-financial corporate debt just prior to the last recession was $3.3 trillion and it has risen to $6.2 trillion (see attached chart).  Almost there, stay with me.  What about consumer credit?  Consumer credit, which includes credit cards, auto loans, etc went from $2.5 trillion to $3.9 trillion (see attached chart).  Finally, and for perspective let’s consider mortgage debt.  Remember that?  One of the major causes of the financial crisis and subject of many books and at least one really entertaining movie.  Just prior to the crisis outstanding mortgage debt was $14.1 trillion.  It peaked at $14.8 in 2008 at the height of the crisis and then bottomed out at $13.3 trillion by 2013 as a result of the fallout.  By the first quarter of 2018 outstanding mortgage debt was back up at $15.1 trillion, the highest level since 1950 (see attached chart).  Now a quick word on why.  An extended period of low interest rates!!  When money is cheap companies and people borrow.  That is all healthy as long as borrowers are able to pay for the debt.  In an expanding economy the system works really well.  If a recession occurs and sales go down and jobs are lost… well that will have to be the plot of another movie in the future (hopefully the far future).  Is debt expanding? Yes.  Are we in a debt bubble? Yes. Does that mean disaster?  No, as long as the air is let out slowly when things start to slow down.  That would be up to the Fed and the Congress.

Speaking of the Fed, Jerome Powell will be speaking mid day today and all eyes will be on him.  The President said in an interview last night that he regrets hiring Powell, but don’t expect that to affect the content of his speech.  Thankfully, Mr. Powell is an economist and not a politician (not that one is better than the other).  Powell will most likely stick to the party line of: things are good but not perfect, trade can be an issue, and future moves will be prudent and data dependent.  Any deviation from the party line will definitely affect the markets.  We got GDP numbers this morning and they reflected a quarter over quarter annualized growth rate of +3.5% right on expectations.  The quarter over quarter core PCE number came in slightly lower than expected at +1.5%.  Later this morning we are expecting new home sales to have grown at +4.0% after last month’s decline of -5.5%.  All eyes will be on the Fed today as markets are pointing to a positive open.  Tomorrow we get the Fed minutes and the President will head down to Buenos Aires for a dinner meeting.  A very important dinner meeting.  Please call me if you have any questions.

AAA spreads

BB spreads

daily chartbook 2018-11-28

consumer credit

corporate debt

federal debt

mortgage debt