Easy Credit, Elevated Valuations, Bulge of BBB Debt
Claudio Borio strikes an ominous tone in the BIS 4th Quarter "On the Record" Media Review, emphasis mine.
Despite the tightening in the period under review, from a longer-term perspective US financial conditions are still comparatively easy. This is so even if one considers the stock market rout - in fact, valuations remain rather elevated. Despite the steady increase in credit spreads, nowhere are easy financial conditions more evident than in the leveraged loan market, which continues to be overstretched. And the bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors. Should this debt be downgraded if and when the economy weakened, it is bound to put substantial pressure on a market that is already quite illiquid and, in the process, to generate broader waves.
Since the early 1980s economic downturns have been triggered more by financial booms gone wrong than by monetary policy tightening to quell inflation flare-ups.
The market tensions we saw during this quarter were not an isolated event. As already noted on previous occasions, they represent just another stage in a journey that began several years ago. Faced with unprecedented initial conditions - extraordinarily low interest rates, bloated central bank balance sheets and high global indebtedness, both private and public - monetary policy normalization was bound to be challenging especially in light of trade tensions and political uncertainty. The recent bump is likely to be just one in a series.
Financial Cycle and Recession Risk
In "The financial cycle and recession risk", Claudio Borio, Mathias Drehmann and Dora Xia make a case that indicators of the state of the financial cycle do a better job than a flatter yield curve in signalling recession risks.
The term “financial cycle” refers to the self-reinforcing interactions between perceptions of value and risk, risk-taking, and financing constraints (Borio (2014)). Typically, rapid increases in credit drive up property and asset prices, which in turn increase collateral values and thus the amount of credit the private sector can obtain until, at some point, the process goes into reverse. This mutually reinforcing interaction between financing constraints and perceptions of value and risks has historically tended to cause serious macroeconomic dislocations.
Financial Cycle vs Business Cycle
Based on its credit parameters, the BIS believes financial cycles tend to last 15-20 years while business cycles last about 8 years.
Financial cycle peaks tend to coincide with banking crises or considerable financial stress. This is not surprising. During expansions, the self-reinforcing interaction between financing constraints, asset prices and risk-taking can overstretch balance sheets, making them more fragile and sowing the seeds of the subsequent financial contraction. This, in turn, can drag down the economy and put further stress on the financial system.
That BIS statement is certainly accurate and is precisely what I have warned central bankers about for years. In their foolish worries over routine "price deflation", the Fed has fueled massive credit bubbles guaranteed to implode.
Increasing Amplitude of Financial Bubbles
This BIS question caught my eye: "Why has the amplitude of financial cycles grown since the early 1980s, raising their importance for economic activity? The reasons are not yet fully understood, but arguably changes in policy regimes may be partly responsible."
The BIS failed to consider a highly likely answer: On August 15, 1971, President Richard Nixon officially closed the gold window.
Nixon Closed Gold Window
Median Home Prices
Real GDP vs Debt
The BIS looked at three variables to analyze recession risk: The composite financial cycle, the debt service ratio (DSR) and the term spread (the difference between the 10-year government bond rate and the three-month money market rate)
The BIS defines debt service ratio as "interest payments plus amortization divided by GDP."
When we run a horse race against the term spread – the indicator most widely used to assess recession risk – we find that they [financial cycles?] outperform the term spread in both in-sample and out-of-sample exercises. The debt service ratio is particular effective in this aspect."
Debt Service Ratio
I downloaded the BIS Debt Service Data which was updated on December 16 and created this chart.
I see nothing "predictive" in that chart. At best, it's a coincident indicator.
The data only goes from 1999 to present, so it only covers two recessions. Let's hone in on the last one.
Debt Service Ratio Data
The Great Recession began in December of 2007. Non-financial leverage peaked in the second quarter of 2008. The private non-financial sector peaked coincident with the recession.
The the US household debt service ratio peaked in the second quarter of 2007 but it was not clear the top was in until the second quarter of 2008.
And the latest data, as of December 16, is only from the second quarter.
Expect Default "Waves"
Perhaps I am missing something, but as I see it, the main value in the BIS report is not this new proposed tool.
Rather, it it the clear warning of BBB corporate debt hovering just above junk that "if and when the economy weakened, it is bound to put substantial pressure on a market that is already quite illiquid and, in the process, to generate broader waves."
On that score, I could not possibly agree more. As I have noted on many occasions, the Fed's insistence of defeating routine deflation is a huge part of the problem.
CPI Deflation Not a Problem
The BIS did a historical study and found routine deflation was not any problem at all.
"Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the study.
For further discussion of the BIS study, please see Historical Perspective on CPI Deflations: How Damaging are They?
Rise of the Zombies
Meanwhile, take stock of the [Rise of Zombie Corporations](Rise of the Zombie Corporations).
And take another look at the lead chart There Have Never Been So Many Bonds That Are Almost Junk.
Credit Spreads Signal Recession
Finally note that $176 billion worth of corporate bonds has fallen from 'A' to 'BBB' so far this quarter - the highest since late 2015.
Importantly, and unlike 2015, it's not just oil-related.
Indeed, Credit Spreads Signal Recession, which is precisely what the BIS is worried about.
Mike "Mish" Shedlock