The Pending Economic Shift

While the focus of my blogs is generally on business and the economics that impact businesses, I wanted to share with you some data that has recently caught my attention.  It clearly shows that the financial institutions are positioning for a change.  Let me see if I can explain the charts in a way that helps us understand what they mean. 

Chart #1 – Swap spreads are the costs to swap fixed rate payments for payments based on floating rates in derivative markets.  It is expressed as a spread, in basis points, over yields on underlying Treasuries.  With that being said, a brief explanation may be helpful.  Swap spreads are indicators of how banks feel about doing business with each other.  When times are good and credit risk is low, the number drops.  That means that banks charge each other less money (or premiums) for doing business together.  Equally, when banks have concerns such as risk associated with other banks credit quality or volatility, the spread increases.  As you can see from the chart, the spread (costs and interest in doing business between banks) has exploded almost 700% from 9.6 basis points in March 2010 to 64 basis points currently.  That means that the concerns banks have regarding doing business with each other has all of a sudden taken a major NEGATIVE turn.  This spread is at a 13-month high.   

Chart #2 – This chart looks at the LIBOR rates banks charge each other to borrow money for short periods of time.  LIBOR is the European equivalent of our Federal Funds rate (what the government charges banks when lending them money).  When credit markets are functioning normally, short-term LIBOR tends to move in accordance with the Fed Fund rates.  However, when they are out of alignment, the LIBOR costs rise as banks take into account the risk associated with the possibility that the money they are lending may not be paid back.  As you can see, the LIBOR (borrowing costs) has more than doubled since December 2009 from 25 basis points to 54 basis points.  A lot of this has to do with Sovereign Debt concerns through the European Union.  Although this is still low, it is at the highest level it has been in over a year.  Most important, it is coming at a time when the European Central Banks and Federal Reserve have elected to NOT raise their interest rate.  To summarize, this is a sign that the markets around the world are perceiving a major shift in risk that will impact lending and banking globally.  Credit is going to get tougher and probably more expensive. 

There is one other important parameter that shows that the concerns over global economic risk are on the rise and moving very quickly.  That is the credit default swap market.  This is basically where financial players buy and sell insurance against credit risk.  When times are good, insurance is cheap.  However, the costs of this insurance are escalating at an alarming rate.  Right now the insurance to insure a benchmark portfolio of $10 million of investment grade corporate bonds against default is about $131,000.  In January 2010, the same insurance would have cost $76K.

Finally, there is one other piece of information I read this week that you might find interesting.  The IMF studied 122 global recessions and found that the recovery time for a global recession that included problems with financial institutions (which is considered a foundational component of all modern economies) was over 5 years.  That means the recovery for our current recession has a couple years left.  Their research indicated something very important to understand about economic recoveries – when structural problems exist, it takes longer to recover.  I would note that this research was done on recessions vs. depressions.   When the level of problems takes any economy toward a depression, then the consequences tend to be much greater and the recovery time tends to be much longer. 

 So what does all this mean and why am I sharing it with you?

1.  The last time these “credit crisis indicators” were flashing red was right before the stock market meltdown of 2007-2008.  If the market takes a big plunge, it will not only hurt investments but it will put a huge fear in the marketplace.  The fear will impact consumers and businesses.  That means it will show up in spending, hiring, investments, confidence, etc.  In reality, consumers have already begun adjusting their thinking.  The average amount owed on credit cards has dropped from $5600 per person to $3,900 per person.  In families with incomes over 50,000, they have cut their credit card debt in half.  The challenge is that the last time we had this level of unemployment (in the early 80’s), the per capita debt was $14K but has now exploded to about $44K.  Be smart with your debt and work hard to eliminate or decrease it over time.
2. Governments around the world have taken unprecedented steps (borrowing money, printing money, etc.) to avoid the global economy’s need to make some tough choices.  History has shown that bailing out, backstopping and popping up institutions and assets during a private credit crisis vs. letting the markets correct themselves, comes with consequences.  In essence, what has occurred is that governments around the world have replaced Wall Street debt with Sovereign debt (debt for each country).  The underlying problems of the global economy have NOT been solved but only delayed.  Even worse, the governments around the world have historical levels of debt which ultimately will come at a huge cost to consumers around the world (taxes, fees, inflation, job stability, etc.). 
3. In my opinion, the de-leveraging of the global economy will be a long and painful process.  Don’t make decisions as if our economy is going to be “business as usual”.  Understand this “new economy” will require you to think and operate differently.  As Japan showed us, long-term economic winters create paradigm shifts in thinking.    
4. Those that are NOT prepared will suffer the worst.  Equally those who are prepared will be an example of a lesson that history has taught us through economic winters – chaos and adversity are often the catalyst to opportunity.

Given this data, it is my opinion that the big institutions are getting positioned for the next level of awareness that the global economic winter is here to stay.  Don’t drink the Kool-Aid and think it will be “business as usual” anytime soon.  Of course societies will suffer but I suspect they will also grow.  Change is often tough but the end result of financial change will benefit society and economies around the world.  It is important to understand how to grow in this type of an economic shift.  As I often advise:  the most important strategy you can incorporate right now is to FOCUS YOUR ATTENTION ON MAKING MORE MONEY.  For those with income stability and cash reserves, the world will be filled with opportunities.  Now is the time to move in that direction. 

One final comment:  This is NOT a “Chicken Little” blog.  The sky is not falling and the world is not coming to an end.  Cycles are a part of every aspect of life.  Change is the only constant.  If you focus on what you can control and use awareness as a tool to make good decisions, solve problems well, and to fuel discipline, YOU CAN SUCCEED IN ANY ECONOMIC CYCLE!!!!!!!!!!!