Monday’s post focused on key economic indicators. Today’s post focuses on key financial indicators, which for the most part are market-driven and available in real-time. As such, they should carry more weight in one’s assessment of the economy’s fundamentals. They aren’t subject to estimates or adjustments or revisions, and they are the net result of the fears, hopes, judgment and actions of countless millions of economic agents and investors. Right now, they paint a picture of a market and an economy that are fundamentally healthy, even though investors are still worried about the future.
If I were stranded on a desert island and could only access one chart to tell me what was going on in the world, Chart #1 is the one I would pick. There are many ways of thinking about swap spreads. (For a detailed explanation, see this post of mine from many years ago.) Swap spreads are excellent coincident and often leading indicators of financial market and economic health. When spreads are low, liquidity is generally abundant, risk aversion is low, systemic risk is low, and the economic outlook is generally healthy. 2-yr swap spreads today are unusually low, less than 20 bps. Among other things, this tells me the banking system is healthy and there is no shortage of liquidity. Morever, market participants are willing and able to manage risk in a variety of ways. That’s an essential function of markets: to redistribute risk from those who don’t want it to those that do. When markets are free to operate and those who worry are free to reduce their risk, panic is short-circuited, and there is no rush for the exits. Low swap spreads act like grease for the wheels of finance, and healthy financial markets are a necessary, if not sufficient, condition for a healthy economy. This is very positive.
After swap spreads, I’d want to know what the Fed was doing. For that, I’d pick Chart #2. Although they rarely mention it, the Fed’s primary monetary lever is the real Fed funds rate (the nominal rate minus inflation according to the Core PCE deflator). That’s the rate that really matters to the economy, not the nominal rate; 5% interest rates in a zero inflation world are much more onerous than 5% rates in a 4% inflation world. As Chart #2 shows, it turns out that every recession in the past 60 years has been preceded by a significant rise in the real Fed funds rate. What was the Fed doing to make real short-term rates rise? It was draining reserves from the banking system. Faced with a shortage of reserves, banks needed to bid in the Fed funds market for reserves (reserves are required to collateralize deposits), and that had the effect of pushing up overnight lending rates. Rising real rates made borrowing more expensive, and it made holding cash or cash equivalents more attractive: the net result was an increased demand for money. So, prior to every recession the Fed effectively starved the markets and the economy for money (because the demand for money exceeded the supply of money), until economic activity slowed down and a recession set in. Then the Fed began to ease, and the economy began to recover. Lather, rinse, and repeat.
It’s going to be different this time, however, because since late 2008 the Fed has changed the way it operates. Bank reserves used to pay no interest, so banks always tried to minimize their holdings of reserves. Today the Fed does pay interest on reserves, so now reserves are a potentially attractive asset class, not a deadweight burden for banks. Reserves today are essentially T-bill substitutes that the Fed created by buying notes and bonds from banks: they pay a floating rate of interest and they are default-free. Not surprisingly, today the banking system is happy holding some $1.6 trillion of excess bank reserves. Banks have all the reserves they could possibly need to cover a potentially huge increase in lending activity, but they are content to hold excess reserves in lieu of making more loans. Bank lending is expanding today at a reasonable rate, and inflation is low.
The main reason the Fed has been trying to reduce its balance sheet is to minimize the risk that a huge amount of excess reserves might encourage banks to lend too much and to thus over-expand the money supply, which in turn could cause a lot of inflation. But so far, raising the interest rate it pays on reserves has been sufficient to induce the banks to view excess reserves as a valuable asset, not as a means to expand lending.
In the 5 years preceding the crash of 2008, Bank Credit grew at a 9.4% rate (see Chart #3). Since the economy began to recover in mid-2009, Bank Credit has expanded at a 4.1% annualized rate; over the past 5 years, Bank Credit has expanded at a 6% rate. Bank Credit growth has picked up a bit in the past few years, but it is clear that banks are not creating new money with abandon, as they seemingly did in the run-up to 2008. The Fed, in other words, has managed to find the interest rate that appears to balance the supply and demand for money. That helps explains why inflation has been low and relatively stable, and the dollar has been reasonably strong and relatively stable.
The yield curve today has become a lot less steep than it was not too long ago, but real short-term interest rates are still relatively low. All that tells us is that the market now expects the Fed to be on hold for the foreseeable future. Consider Chart #4, which shows the Dec. ’19 Fed funds futures (i.e., the market’s expectation for what Fed funds will trade at come December). Fed expectations a few months ago called for two more tightenings, but the economy’s weakness and concerns over trade tensions, etc., have convinced the market (and also the Fed, which recently apologized for threatening to raise rates more) that this won’t happen. Today’s funds rate target is 2.4%, and the Dec. ’19 Fed funds futures rate is trading at just under 2.5%. So the market expects the Fed to essentially be on hold for at least the rest of this year. This is an important variable to watch, since it is tied directly to the market’s perception of whether the economy is gaining or losing strength; for example, any tendency towards a stronger economy would cause the market to raise its expectations for where the funds rate will be come December.
Chart #5 sheds further light on market expectations for Fed policy. The real Fed funds rate (blue) is the overnight real interest rate that sets the floor for all other rates (it’s also the same rate that appears in Chart #2). The real yield on 5-yr TIPS (red) is a good proxy for what the market expects the real Fed funds rate to average over the next five years. The current real funds rate is about 0.6% (a 2.4% Fed funds target minus a core PCE inflation rate of 1.8%). The market expects the real funds rate to average about 0.9% over the next 5 years—a very modest tightening of policy, but certainly not an easing.
Note the relationship between these two variables. The real yield curve tends to invert prior to recessions (i.e., the blue line exceeds the red line). This happens because the bond market senses that the Fed is so tight that it is undermining the economy, and that in turn will lead to a recession and much easier Fed policy in the future. Currently the real yield curve is still positively sloped. The bond market is not signaling a recession, but neither is it signaling strong growth—real yields are still relatively low.
Chart #7
Chart #15 compares Warren Buffet’s favorite measure of equity valuation (blue line) to the inverse level of 10-yr Treasury yields (red). It suggests that equity prices had reached high levels relative to nominal GDP earlier this year, but that this has been “corrected” by the recent decline in equity prices combined with ongoing growth in the economy. The chart further suggests that the current valuation of the market is consistent with the level of interest rates (compare the current period to the late 1950s and early 1960s). That equity valuations using the Buffet measure tend to inversely track the level of interest rates over time is not surprising, since lower lower rates result in a higher discounted present value of future profits, and vice versa.
Finally, let’s look at something interesting from China. Chart #16 compares the value of the Chinese yuan to the level of China’s foreign exchange reserves. Here we see that the yuan has taken a beating in the past year or so (undoubtedly as a result of a significant reduction in the pace of China’s real growth and a significant increase in uncertainty surrounding the Trump tariff wars). But it’s very interesting to see that China’s forex reserves have been holding fairly steady for the past two years. This tells me that China’s central bank has been successfully stabilizing its holdings of reserves by allowing the yuan to fluctuate within reasonable limits. This further implies that the central bank is keeping the supply of and the demand for yuan in balance, which should keep China’s inflation low, help stabilize the economy and in turn restore confidence in the currency. The recent upturn in the value of the yuan likely reflects the market’s belief that a resolution to the US-China Trade War could be in the offing. I wouldn’t be surprised at all, since Trump’s ultimate objective is a reduction in tariffs and subsidies, and that in turn would be good news for both the US and Chinese economies.
