Economic growth is slowing, Fed chairman Ben Bernanke noted in a speech yesterday, but he predicted that “growth seems likely to pick up somewhat in the second half.” He blamed the recent stumble, including last month’s sharp decline in the pace of job growth, on higher gasoline prices and the crisis in Japan that created trouble for the global manufacturing sector.
Talk is cheap, of course, and there are enough economists in the world so that you can find any prediction you want. The question, as always, is whether there’s any support in the latest data for a given outlook? On Monday, I noted that it looked like the stock market was still giving growth the benefit of the doubt. Can we say the same for the credit market?
Before we take a look at the numbers, a quick review for deciding if we should even be looking to credit trends for clues about macro. One of the empirical “facts” in using markets to anticipate the business cycle is relating credit spreads to expected changes in GDP. As Antti Ilmanen reminds in his new book Expected Returns: An Investor’s Guide to Harvesting Market Rewards: differences in yields between corporate bonds and risk-free Treasuries are countercyclical so that spreads tend to fall during expansions and rise in recessions (Chapter 26).
Numerous studies over the years make similar observations. A 2001 review by the IMF, for instance, finds that “the yield spread of investment-grade bonds relative to Treasuries, a proxy of default risk, predicts marginal changes in industrial production in the United States up to 12 months in the future…” A more recent paper (“The cyclical component of US asset returns” by David Backus, et al.) notes that “decades of research has found that steep yield curves (and large term spreads) are associated with above-average future economic growth.” Another recent working paper (“Credit Spreads and Real Activity” by Philippe Muellery of the London School of Economics and Political Science) reports that “credit spreads over the whole spectrum of rating classes are suited to predict future GDP growth up to a horizon of three years.” Muellery adds that “the credit factor is highly correlated with the index of tighter loan standards, thus lending support to the existence of a transmission channel from borrowing conditions to the economy.”
With that in mind, let’s consider recent history on several credit fronts, beginning with the daily yield spread between corporate bonds rated Baa, which are considered “medium-grade” credits, and the benchmark 10-year Treasury Note. This spread remains near the lowest levels reached after the Great Recession ended in mid-2009. Nonetheless, the spread has inched higher recently. If it continues to rise in the weeks ahead, that may be an early warning that the market is become incresingly skeptical of Bernanke’s forecast of stronger growth in this year’s second half.
The second chart below is another measure of the credit spread, this time using “junk” bonds, based on credits rated CCC or below via the Bank of America Merrill Lynch US High Yield Master II Index. The recent trend corroborates the sentiment in the chart above, perhaps more so, given that the junk spread is near its lowest level reached since the recession ended.
A third piece of evidence is the Treasury yield curve, which remains firmly positive. Indeed, the 10-year’s Treasury yield is roughly 3% at the moment, a near-300-basis point premium over the virtually zero-yielding 3-month Treasury bill. As J. Anthony Boeckh notes in The Great Reflation, “the yield curve is an exceptionally powerful indicator of liquidity changes and the state of the economy over the course of the business cycle.”
Finally, let’s review the trend in lending, which has been known to drop clues about the future path of the economy. “If lending picks up,” writes Anthony Crescenzi in Investing From the Top Down: A Macro Approach to Capital Markets, “you can bet that corporate spending will too. This indicator therefore is a good guage of business confidence….”
Based on the latest weekly numbers from the Federal Reserve, the dollar amount of commercial and industrial at large commercial banks continues to rise, as the next chart below indicates. It’s hardly a roaring surge, but the fact that the value of new loans are rising offers another data point in support of the optimism suggested by credit spreads of late.
The trend also appears favorable by way of the Fed’s quarterly survey of demand for new commercial loans, although these numbers arrive with a lag. That said, as the latest survey reports,the demand for commercial and industrial loans (C&I) and for commercial mortgages increased.
It appears that the credit markets are in agreement with the stock market’s forecast that growth will prevail. Market’s can be wrong, of course. No less is true for predictions by Fed chairmen. And market conditions change as well, and so we should closely monitor spreads for any shifts. But for the moment, at least, it seems that there’s still a case for keeping an open mind about the next phase for the economic cycle.