Is The Credit Market Signaling Recession?

Stocks are slightly off their all-time high, but remain over extended according to most valuation metrics. The hope investors have is for tax cuts. Even though the GOP appears dysfunctional, all its members want to cut taxes. All hope for a tax cut isn’t lost, but the difficult part is finding cuts in the budget to pay for them. The other option is the politically divisive border adjusted tax. The market believes ‘where there’s a will there’s a way’ when it comes to getting bills passed. However, that didn’t work with health care reform. Sometimes promises politicians make are impossible to keep.

As I mentioned at the outset, the stock market is expensive according to most valuation metrics. The stock market is expensive because of the relentless run-up without a pause. We remain in the longest period of this bull market without a 5% correction; this bull market is the second longest in the history of the S&P 500. This consistency in the bull run has led to the chart on the left. It shows the z-score of various indices. The Russell 2000 has a z-score of about 1.5 which signals complacency. The times when the market has historically been complacent and fearful are shown in the chart on the right. The chart shows the indicator has a mixed track record. It correctly gave bullish signals in 2011 and 2015, but incorrectly gave a bearish signal in 2013. The indicator being wrong in 2013 doesn’t mean we should ignore it because many indicators which have had a historically great track record have been stymied by this bull market.

The most important indicator of the health of the economy is the commercial and personal loan market. Businesses have too much debt. Therefore, the only way to keep the music going is to keep the credit being issued. The precise time when businesses need loans the most is when the spigots turn off. Think about it in terms of a consumer. When you have paid all your bills on time, the banks and credit card companies are begging to give you a loan. When you have maxed out five credit cards, no one wants to give you a loan. The commercial credit market is maxed out. The chickens are coming home to roost. As you can see in the chart below, the three-month corporate lending is down 1.6% which is the worst since 2011. This is a yellow light signal, not a red light. The reason the yellow-light is more important now than in 2011 is because the corporate leverage is much higher. It’s near the peaks of the last two cycles. This recession has been delayed by the Fed in February of 2016 and the post-election Trump animal spirits, but it’s still coming.

Not only is C&I lending slowing 5.4% and overall corporate lending slowing 1.6% (both on a three-month basis), but the bond market also started decelerating in March. As I mentioned in a previous article, the bond issuances were on pace to grow 18% in the first two months of the year. This is an unprecedented speed because it grew 1.4% last year and 2.6% in 2015. Corporations issued all that debt because they wanted to get in ahead of the Fed’s rate hikes and the rising yield environment brought about by Trump-flation and Trump-growth. As you can see in the chart below, corporations are also worried the yield spread is going to start to increase again since it’s near the 2014 bottom. The part I circled is the recent increase in spreads. It’s tiny compared to the tightening of early 2016.

I know bond issuances have started to decline because as of March 13th, the total issuance was only up 14% year over year. That’s a four-point drop in year to date growth in only two weeks. Assuming straight-line growth in 2016, the back of the envelope math says the first two weeks in March saw about a 2% drop in corporate bond issuances. The chart below shows the total bond issuances for Q1. The great first two months of the year masks the recent slowing.

The 10-year bond yield peaked on exactly March 13th. We’ll have to see what happens in the next few weeks to determine if the downturn was caused by rising yields. The yield spread increased less than the 10-year yield fell meaning corporate borrowing rates improved since March 13th. I may be over analyzing the decline in bond issuances because it may simply be that more bond issuances were planned for January and February than for March. Lumpy growth means this two-week slowdown could be ‘much to do about nothing.’

I have discussed the handoff between monetary and fiscal policy many times in articles. The chart below gives a visualization of the anticipated deceleration of central bank balance sheets. The tiny quarter point Fed rate hikes are nothing compared to the global central bank balance sheets. I continue to not believe in the projections for the Fed to unwind its balance sheet. I don’t think the global markets will be able to handle such an easing off the gas pedal of monetary stimulus. Sometime between now and when growth is expected to go negative in late-2018, there will be a crisis which causes central bankers to change their plans. Anyone worried about the fiscal cliff created by the debt ceiling in September is missing the mark. The true monetary cliff is about to be hit as the ECB will slow asset purchases by $20 billion in April.


Just as the economy is about to fall into a recession, global central bankers have decided now is a great time to slow their asset purchases. The only time central bank balance sheet growth was negative since the beginning of this cycle was right after the giant infusion of capital in 2009. That only lasted a few months. The prospect that central bank balance sheet growth will go negative in 2018 and stay negative for years, is impossible in my view. Something in the economy will break before 2019. As I showed, total loan growth is negative; the U.S. economy is not on solid footing.

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1 Comment

  • Bill

    March 28, 2017

    Does ToS provide Z-score? Is John Galt a pen name?