Credit Rundown Of Opposing Propositions That Aren't Necessarily Opposed

by: Alhambra Investment Partners

By Jeffrey P. Snider

There is an interesting dichotomy taking shape in credit markets, including those around the globe (that will be a separate post). Some of this, I think, relates to what FOMC member Richard Fisher related today about concerns over asset bubbles. I think the Economic Times of India summed him up the best:

Already there are signs of financial excess in markets, he said, and although inflation currently is not a problem, continued low rates could spark unwanted price pressures.

Waiting too long to raise rates could ultimately force the Fed to raise them sharply, he warned, potentially driving the economy into another recession.

That raises a potential wedge between credit markets digesting "forward guidance" of rate policy against the very same markets trying to gauge economic risk. Given the dynamics of yield curves, the proportionality of one or the other changes as you move along the curve. The shorter end, obviously, has shown itself far more susceptible to Fed manipulations around expectations, while the longer end, as I showed awhile back, has a very good (or used to) correlation with economic growth.

What if we arrive at a situation where "excess in markets" is deemed too much to ignore, but economic growth remains subpar (or worse)? I don't think we are far off that proposition now, and I believe that is what credit markets are beginning to entertain, if not already reflect in some manners.

In general, bond yields have been rising this month, but the curve in each segment has not much changed in terms of steepening - at least not to the degree which might be associated with a stern bond selloff. Instead, the curve shape has mostly maintained that dramatic flatness it absorbed in August. So what we end up with is a still-flat curve shifted upward to a nominally higher "attachment point" where the influence of QE and ZIRP end.

The broader curve shapes certainly reflect that, if the belly has moved a bit more steeper. That might make sense if what is being raised is accurate, as such a condition would likely produce more than a fair amount of uncertainty, if not confusion about rate paths and credit "equilibriums" under these conditions.

I think the economic aspect, the pessimism, is reflected in inflation breakevens that are now moving below their "dead" range. That would contradict, apparently, Fisher's concerns over all price increases and instead place the focus of "inflation" squarely on assets.

For all the previous talk about actual inflation (in the orthodox definition of prices and wages) there is very little of it now; and what there is generally isn't good. With commodity prices seemingly reflecting a reset in global growth expectation, if not completely enthralled by a "higher" dollar as the massive dollar short globally seems to be unwinding, the only "excesses" remain financial. Both of those circumstances would be highly "bearish" toward US growth prospects, which, as we know from supply chain dynamics, is deeply intertwined with economic prospects for the entire globe.

I think this reset, if that is an appropriate term, is most evident on the eurodollar curve. The flatness the curve took up to the end of August is still there, just shifted to a higher interest rate level. In fact, in the past week, the eurodollar curve has "flexed" slightly more flat with the same exact "attachment point" around 2017.

That notice is somewhat confirmed, though not cleanly, by swap spreads that look to be anticipating here and there an upward interest rate pressure in the short ends.

So we have a situation across credit and funding markets that looks to be higher but still flat. In other words, it appears as a reflection of Richard Fisher's potential worries about certain "excesses" without Janet Yellen's self-assured positivity about growth. Not exactly an inspiring combination, but such is "mysterious" secular stagnation.