Another wall of worry

Once again markets are consumed by fears of another global collapse, this time triggered by super-low oil prices and a struggling Chinese economy. These two factors first surfaced last August, only to subsequently subside, but now they have returned with a vengeance. We haven't seen anything this bad since the PIIGS crisis rocked European markets in late 2011 and early 2012, leaving a recession in its wake. The oil patch, however, is now in full crisis mode, fully reminiscent of the financial panic of 2008, as the market is pricing in extensive and painful debt defaults. The question that no one can answer is whether the problems in China and the oil patch will lead to crises in emerging markets and eventually recessions in the developed economies. Are we on the brink of another 2008 (a global rout), or is this going to be like 2011 (i.e., localized and transitory)? My money is on the latter, but I'll admit to being nervous.

Here are some charts that put the severity of the current situation in perspective:

As with other stock market selloffs, the current one comes accompanied by a significant increase in fear, uncertainty and doubt (proxied here by the ratio of the Vix index to the 10-yr Treasury yield). Panics that result in a big increase in the implied volatility of equity options sometimes bring with them their own solution, since buying options to limit one's risk becomes extremely expensive (thus making it very expensive to sell on dips and buy on rallies), while selling options becomes potentially very lucrative (rewarding those who are willing to buy the dips and sell the rallies). Spikes in fear of this nature thus attract more liquidity to the market, which in turn makes it easy for those who wish to exit. Real panics feed on themselves when the exit doors are crowded and/or shut, but that doesn't appear to be the case today.

Gold prices and TIPS prices (proxied here by the inverse of their real yield) have been trending down ever since the resolution of the PIIGS crisis. I've interpreted this to mean that markets were gradually regaining the confidence they lost, since both assets are safe havens. Gold appears to have broken out of this downtrend of late, suggesting that panic is setting it. 

It's worth noting that industrial commodity prices have been rising in recent months, tracking the rise in gold prices. Outside of the oil patch, it appears that commodity prices are beginning to recover. A weaker dollar is helpful in this regard. But if industrial commodity prices are recovering, that further suggests that the global economy is not exactly collapsing. 

Corporate credit spreads are certainly elevated, but still far below the levels that characterized the 2008 global financial panic.

Default risk is highly concentrated in the energy sector. High-yield energy bond spreads are now at the extreme levels that we saw in the HY market back in 2008. Spreads at these levels indicate that the market is priced to the expectation that a significant number of bonds will default. Back in November 2008 (just prior to the peak in credit spreads) I had a post which discussed the significance of super-wide spreads. I referenced a Lehman analysis which calculated that spreads in the range of 1700 bps implied that 70% of HY bonds would be in default within the next 5 years. I also referenced a Barclays study that said that HY spreads of 1700 implied "3-4 years of a 15% annual contraction in GDP," which would have been far worse than what we saw during the Great Depression. Bottom line, the current level of spreads in HY energy bonds is consistent with catastrophic conditions in the oil patch. The market may be exaggerating the actual risks, but we can say with confidence that it doesn't get much worse than this.

As I've been noting for quite some time, it remains the case that swap spreads are very low despite the elevated level of corporate credit spreads. This is a significant non-confirmation of the distress in the HY sector. Although the market is extremely pessimistic about the prospects for the oil patch, and quite concerned about the health of speculative bonds in general, the bond market as a whole exhibits little if any systemic risk and generally healthy liquidity conditions. Swap spreads were good leading indicators of the distress in prior recessions, but this time around it's very different. At the very least this suggests that the market's level of panic is exaggerated—that the underlying fundamentals are not as bad as the panic would suggest.

The chart above suggests that the decline in near-term inflation expectations can be fully explained by the decline in oil prices. Oil prices are depressed because of abundant supplies, not because the Fed is too tight. If overly-tight monetary policy were the driver of conditions today, as it was in the third quarter of 2008, we should be seeing falling gold prices and a rising dollar, much as we saw back then. But the dollar today is weak and gold is rising, which again suggests that it's not tight money that is the problem, it is just very low oil prices.

The chart above compares the real yield on 5-yr TIPS with the ex-post real yield on overnight interest rates. The blue line thus represents the market's expectation of where the real Fed funds rate will be in five years' time. As it stands, the market is expecting real yields to rise from their current level of -0.9% to about zero. That is properly characterized as monetary policy becoming gradually "less easy" over the next five years. Nobody is expecting the Fed to actually tighten policy (which would show up in this chart as a narrowing of the spread between the red and blue lines) for the foreseeable future.

Finally, the chart above compares the equity market in the U.S. with its Eurozone counterpart. The current crisis has affected Europe much more than it has the U.S. The magnitude of the current decline in European equities is similar to what happened as a result of the PIIGS crisis and the subsequent Eurozone recession. 

Things are ugly out there, but I don't think we are on the cusp of the end of the world as we know it.