Over the course of the past two months we have witnessed some stabilization in the financial markets as stocks have staged a strong rally and credit spreads have come down. While we have seen stabilization in the financial markets since the March lows the stabilization process actually began after the October 2008 panic lows. After the collapse of Lehman the markets came unglued and the Federal Reserve and Treasury worked over time creating lending facility after lending facility to ease the various sectors of the financial markets, and looking back, one would have to conclude they have largely been successful. But the question that lies ahead of us is whether or not their financial efforts will gain economic traction. Basically, do the recent green shoots have roots?
You can see the improvement in financial markets below in the FSO US Financial Stress Index (FSI) that has risen considerably since October. The FSI has already breached its January highs after a period of consolidation, nearly retracing most of the post Lehman fallout, though still not into positive territory. All of the component indices within the FSO FSI also show improvement, signifying easing in stress levels in all of the various financial markets.
Source: Financial Sense Online
Source: Financial Sense Online
One of the areas that I have been monitoring closely over the last several months in terms of gauging the anxiety of the markets as well as the force of deleveraging is the currency markets. The collapse of Lehman led to the unwinding of the yen carry trade in which cheaply borrowed yen was used to invest in higher yielding currencies. As the deleveraging process gained force the euro gave back in two months what it had gained in six years in terms of purchasing power relative to the yen. While the weakening of the euro relative to the yen was an early warning heading into the market collapse late last year, the stabilization and strength in the euro relative to the yen this year was an early warning of a coming market advance. As a break below the 200 day moving average (200d MA) was a warning of market stress, a break above the 200d MA is likely indicating greater stabilization in the currency markets and signs of easing in investor’s fears.
Source: Bloomberg
The strengthening in the euro relative to the yen is not an isolated event as many higher-yielding currencies are gaining strength relative to yen, which you can see below in an equal-weighted index of high-yielding currencies relative to the yen.
Source: Bloomberg
Money flowing back into higher-yielding currencies is one sign that investors' appetite for risk is increasing. We are also seeing this in the fixed income market as US Treasuries are underperforming riskier fixed income assets as it appears investors are not only seeking higher yielding currencies but higher yielding fixed income assets as well. This is apparent when looking at the relative strength improvements of fixed income ETFs relative to the Lehman 7-10 Year Treasury Bond Fund (IEF). Investment grade bonds (LQD) and aggregate bond ETFs (AGG) were the first to bottom relative to the IEF and have recently broken out of triangle patterns. The TIPS ETF (TIP) and the high-yield corporate ETF (HYG) bottomed next and have also broken out of triangle patterns as investors' fears begin to ease and they move out on the risk curve.
Source: StockCharts.com
It appears the easing of investor’s fears has been justified given the easing in the credit markets. For example, the Fed’s Senior Loan Officer Opinion Survey for April hit the street on Monday and showed that the peak in tightening in the credit markets is probably behind us. The center of the current crisis has been housing, and the Fed’s survey shows that the net percentage of banks tightening standards for mortgage loans decreased significantly in the first quarter of the year with a slight uptick in the recent quarter, though still well below the wide tightening seen at the end of 2008. Accompanied with the easing in lending standards has been a rising trend in mortgage demand as the net percentage of banks reporting stronger demand has improved and actually turned positive for prime mortgages in the second quarter.
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey
The survey not only showed banks easing lending standards for home mortgages but also for commercial and industrial (C&I) loans. An increase in the percentage of banks easing standards for C&I loans to large and medium firms has positive implications for the stock market as the percentage of banks loosening standards for C&I loans leads the year-over-year (YOY) rate of change for the S&P 500 by six months. This relationship between the two series likely stems from the close link that S&P 500 operating earnings per share shows with the percentage of banks easing lending standards for C&I loans. As C&I loan standards ease S&P 500 operating earnings begin to improve with the stock market following suit.
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey/ S&P
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey/ S&P
Bank easing cycles typically follow the yield curve with a year and half lag. With the current slope in the yield curve we can expect banks to continue loosening lending standards for C&I loans into 2010, which would be bullish for S&P 500 operating earnings and the stock market, not to mention GDP which also shows a close link with the percentage of banks loosening standards for C&I loans.
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey/BEA
Turning to the consumer, improvement in bank lending standards was also seen in the recent survey. For example, the net percentage of banks tightening standards for credit cards and other consumer loans appears to have peaked, a hallmark that occurs prior to the end of a recession.
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey
The easing of bank lending standards to the consumer is the most bullish aspect of the report as consumers make up the bulk of GDP, roughly 70%. There is a close link between the percentage of banks willing to lend to the consumer and consumer spending (real personal consumption expenditures), with banks willingness to lend to the consumer leading consumption patterns by a few months. While there is what appears to be a bottom in consumption levels in terms of the YOY rate of change, we need to see consumer spending improve, which is what the strong improvement in the percentage of banks willing to lend to the consumer is telling us to expect. If we indeed see improvement in consumption patterns ahead, this will undoubtedly have positive implications for real GDP. Bank willingness to lend to the consumer typically leads real GDP levels by three quarters, with the recent improvement forecasting a recovery in GDP levels by the third to fourth quarter of the year.
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey/BEA
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey/BEA
In sum, what we can infer from the data above is that the worst of the credit crisis is behind us, and from historical relationships we know that easing in the credit markets leads to an economic rebound as loans to consumer and businesses begin to expand, spurring economic growth and rising stock prices. While we have indeed witnessed easing in the credit markets we need to remain alert for signs of an economic recovery that the credit markets are forecasting. While the Fed and Treasury have been successful in bringing healing to the credit markets we need to see tangible evidence that their efforts are leading to economic traction rather than simple green shoots. Green shoots are the first signs of an economic recovery but we need to make sure that the green shoots have roots or the next financial rain cloud could wash them away.
Perhaps the greatest indicators for us to look at for signs that the economy is making a turn for the better are the ISM indices and labor markets. The ISM manufacturing index released last Friday showed a strong improvement for April in its Purchasing Managers’ Index, rising from 36.3 to 40.1, with an improvement also seen in its employment index to 34.4 from 28.1 in the prior month. The ISM nonmanufacturing index also picked up in April with the composite index improving from 40.8 to 43.7, with an improvement in its employment index also seen with a rise from 32.3 to 37.0. While the employment indices for both manufacturing and nonmanufacturing remain in contractionary territory (below 50), their rate of decent is moderating, implying that we can begin to see the rate of job losses begin to decline in the months ahead. I created an ISM employment composite based on the weights of each sector’s role in GDP and found that it typically leads the YOY rate of change in employment by three months.
Source: ISM, BLS
The employment composite is telling us to expect the rate of decline in job losses to begin to moderate and we shouldn’t have long to find out as the nonfarm payrolls data for April comes out this Friday. So far the peak in monthly job losses was in January of this year at 741,000 jobs lost during the month, though job losses have moderated since then. Further moderation in April will likely lead to a jump in the markets as investors place their bets that the green shoots have roots. Time will tell.
