Once again, the world is in a tizzy as falling oil prices threaten the profits of the energy sector, which in turn sparks fears that this could spread to the rest of the economy. Once again, I think these fears are overblown. Putting things in perspective, oil prices in real terms are only slightly below their long-term average. The energy sector has taken a real hit, but the evidence of contagion is still hard to come by. Swap spreads remain low, and that suggests that markets are liquid and systemic risk is low, so even though the pain and suffering is acute in the energy sector, the rest of the economy looks fine.
Credit spreads in the high-yield energy sector are quite high, suggesting a meaningful risk of widespread defaults. The average bond in this sector has suffered a 25% drop in price, erasing a total of about $40 billion of the sector's value. That's not chump change, but neither is it an existential challenge to a market (high-yield corporate bonds) with a total market value of $1.3 trillion. Meanwhile, the market value of investment grade corporate bonds is about $5.4 trillion. So the losses in the HY energy sector represent about 0.6% of the value of all traded corporate bonds in the U.S.
The decline in oil prices in the past year has been deep and precipitous, but when viewed from an historical context, all that has happened is that oil has gone from being very expensive to about average.
The chart above suggests that the main reason for the decline in oil prices is a giant increase in U.S. crude oil production. When greater supplies result in lower prices, that is a very good thing for consumers.
As the chart above suggests, monetary policy is not the main culprit behind lower oil prices. We're not talking about a generalized deflation which is the by product of overly-tight monetary policy. The dollar is trading at very close to its long-term average, and so is crude. The dollar has been relatively stable for most of this year, even as oil prices have gyrated. The Fed is not about to "tighten" monetary policy anytime soon (one or two hikes in short-term rates doesn't equate to a tightening—it's just the Fed making policy less accommodative), so there likely is no fundamental shortage of dollars in the world, and no reason therefore to think that all prices are at risk of declining.
Corporate credit spreads in general are elevated, but still far less than they were during periods of recession.
The difference between junk and investment grade spreads is also elevated, but still relatively low compared to periods of great financial and economic stress.
The chart above is key: while credit spreads have risen meaningfully, swap spreads have remained in "normal" territory. Real problems happen when swap spreads rise by a lot, at the same time other credit spreads rise. That's not the case today. Swap spreads are not confirming the supposed contagion risk of defaults in the energy sector. They are saying that the contagion risk of lower energy prices is well contained.
In the chart above we see that 5-yr swap spreads are also quite tranquil, even though spreads in the high quality industrial sector have jumped.
So the current bout of fear and trembling is likely to pass. The market is once again climbing a "wall of worry," worrying about something that has a low likelihood of become a serious problem. This is most likely a correction, not the beginning of another recession.
Those who worry about the value of risky assets must forgo a considerable amount of income in exchange for the safety of cash, as the chart above shows. This is symptomatic of a market that is still quite fearful in general. In effect, the market has priced in a substantial amount of bad news already.
The main impact of lower oil prices has been on inflation expectations, as shown in the chart above. This is how it should be.
For all the fear and trembling out there, gold prices have only managed a minuscule bounce, and real yields on TIPs have been in a rising trend for several years. This chart is not signaling any major problems.
Most importantly, rising real yields and very low swap spreads suggest that the economic fundamentals are improving, not deteriorating.
UPDATE: Here's what the "Wall of Worry" chart looks like as of 10 am PST Aug 21:
We've climbed walls of worry like this one before. I suspect we'll do it again.
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