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Debt Markets’ Eerie Calm Echoes Eve of 2007 Credit Crisis – Silver Doctors

Junk bond spreads this tight are a reason for unease.

It’s Quiet — But Not Too Quiet

When markets get dull, it is an old standby for financial commentators to say that they’re too quiet. But sadly, even that might not be true this time. Or at least, it’s not true of the remarkably steady advance of the U.S. stock market. 

Ever since election week last November, the S&P 500 has avoided a drawdown from top to bottom of even as much as 5%. That’s unusual, and quite a streak. The rest of the world has undergone two mini-corrections in that time. The first, in March, brought it back into line with the U.S., while the second, starting in June, has left the American market far ahead. With the S&P up 35% in the last 12 months, and the rest of the world up 25%, stocks across the globe have enjoyed calm progress:

Intuitively, this seems wrong. So far this year has seen the Jan. 6 insurrection, huge swings in perception of the pandemic, and the horrors of the withdrawal from Afghanistan. After a successful honeymoon, President Joe Biden has run into serious political trouble. And yet none of this has troubled the markets. How come?

If all of this sounds alarming, it’s little more than a rerun of 2017, the first year of Donald Trump’s presidency. The following chart shows daily percentage changes for the S&P over the last five years. The past 12 months has been calm, but 2017 was spectacularly dull, even as Trump was embarking on a controversial and iconoclastic presidency:

The same picture emerges if we use the VIX volatility index, which infers volatility from the options market. Biden has presided over a steady calming in volatility, as measured by the VIX, while Trump’s effect back in 2017 was even more soporific:

So the eerie calm under Biden isn’t in fact so eerie. New presidents, it turns out, tend to preside over periods of relative calm. Indeed, according to Bespoke Investment Group, this is still only the 13th streak of 300 days or more without a 5% drawdown since the S&P’s inception in 1928. The run in Trump’s early days lasted almost twice as long:

If we take another measure of calmness, and look at the average daily move (up or down) in the index over a year, then 2017 was the quietest in more than half a century. Calmer still was the period from 1963 to 1964 which saw the Kennedy assassination and the arrival of Lyndon Baines Johnson — if possible, a period that appears even more traumatic than the hyper-polarized partisanship of the last few years. Extreme political angst doesn’t, in itself, upset markets if there is confidence that financial conditions will stay benign.

Does market calmness like this beget greater volatility later on? The crisis of 2008 had many of us looking up the works of  economist Hyman Minsky, who held that stability creates instability. Easier financial conditions lead to over-confidence and excessive speculation; that creates the conditions for an over-leveraged crash.

The absence of stock market volatility, viewed in isolation, doesn’t necessarily have that effect. The long period of calm under Trump ended with a dramatic market accident as a number of speculators who had been betting on low volatility were forced out of business. The year of 2018 ended with another drawdown as markets revolted at the prospect of steady quantitative tightening by the Fed. But while 2018 was quite a rough year for markets, it was nothing exceptional; it’s hard to make the case that a historically calm year led to a major crash. Similarly, Lyndon Johnson managed to preside over strong equity performance until a brief bear market in 1966. His last full year in office, 1968, was one of the most turbulent in the nation’s history, but a perfectly good one for the stock market, which rose 8%.

Debt Markets ARE Too Quiet

Where Minsky would find more grounds for concern is in the credit market. The calm there is stupefying. And in many ways it is legitimately terrifying. This chart shows the yield on the Bloomberg U.S. Corporate High Yield index, which has been at its lowest ever this year, and its spread compared to Treasury bonds, which is closing in on its record tightest level set ominously on the eve of the credit crisis in summer 2007:

This isn’t merely a phenomenon of the American junk bond market. If we look at the euro zone, where the bond market had to contend with what was in effect an extended crisis that lasted well into the last decade, we see spreads compared to Treasuries reaching record lows as well, on the eve of a European Central Bank meeting:

Credit spreads in Europe haven’t been this tight this consistently since, again, the summer of 2007. In the credit market, unlike stocks, stability like this should ring alarm bells. Investment-grade issuers, and not just low-grade junk issuers, have rushed to issue more debt this week, locking in generously cheap funding while they have the chance. That means that that much more debt will have to be rolled over in future, creating that much more pressure on the Federal Reserve and other central banks to keep the liquidity flowing. If potential lenders aren’t able to refinance that debt in future, then we have the seeds of a Minsky Moment, the point at which investors recognize that debt is unsustainable and lose confidence.

If we take this argument a step further, it suggests that there could be a grave error in what appears to be the current policy of first tapering off asset purchases (which help to provide potential lenders with liquidity by giving them cash in return for bonds they were holding) and only later raising rates. Raising rates while keeping the liquidity going would discourage yet more debt issuance, while ensuring that existing debt can be rolled over safely. That way, conceivably, it might be possible to retreat from the current extraordinarily lenient financial conditions without creating a crisis along the way. 

Mike Howell of Crossborder Capital Ltd. in London puts this view eloquently. Assuming central banks want to avoid a crisis, they may find that they have no choice but to steer the U.S. and euro zone into Japanified conditions with permanently low rates leading to permanently high levels of debt, forcing central banks to continue be lenient:

The impact of more debt on the economic outlook needs to be carefully considered. The issue (again-and-again) is that the world economy is burdened by too much debt, rather than too much liquidity. Liquidity has become a necessary counterpart of debt, because (unlike equity) debt needs to be re-financed on maturity. With the average maturity of the near-US$300 trillion of World debt standing at around 5 years, this suggests close to US$60 trillion needs to be rolled over each year. This whopping funding burden demands a lot of balance sheet capacity, i.e. liquidity.

[L]arge debt burdens are forcing the West to converge on to Japanese-like inflation rates and interest rates.  Japanification is coming and low yields will persist unless the unending rise in debt is stopped! Too much debt is the problem, not too much liquidity.

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