Three In A Row...

Two days ago, when looking at the latest "Senior Loan Officer Opinion Survey on Bank Lending Practices", we showed that Fed lending standards had tightened for the third quarter in a row, and pointed out that in recent history this has never happened without either a default cycle, or a recession, following immediately after.

 

Today, as part of its brand new daily report "Credit Bites" titled "3 in a row..." Deutsche Bank takes on the same subject, and notes that the April survey showed that on balance, banks tightened lending standards on commercial and industrial loans during Q1, even if lending standards on loans to households were said to have eased. It then updates a couple of charts DB uses to show the correlation between the C&I Loan Standards and US HY defaults (12 months on) and also that the yield curve is a good lead indicator of the direction of lending standards around 18 months in advance.

From the note:

We've now seen three consecutive quarters of net tightening of C&I lending standards in the US (Figure 1, left) and previously whenever this has happened it has ultimately led to a full blown default cycle – albeit with only three cycles of data to examine. The series does tend to exhibit sweeping cyclical tendencies with momentum and is not prone to random fluctuations. So it's a worry that we've entered the net tighten stage and have stayed there for three quarters now. The good news is that although it points to a continuation of the rising default trend over the next 12 months, the net tightening (+12) is still relatively mild.

 

 

The shape of the yield curve suggests more tightening to come though (Figure 1, right). A reminder that we like the yield curve as a lead  indicator as it is in our opinion a very good proxy for animal spirits. When the yield curve is steep, animal spirits should be high as the risk rewards to investing out the curve are high. The opportunity costs of being defensive at the front of the curve are potentially very high. When the yield curve flattens the risk/reward reduces and animal spirits should fade and lending standards should gradually tighten. To exaggerate to illustrate when we have an inverted yield curve animal spirits should be severely curtailed as any kind of lending/investing out the curve carries a poor risk/reward profile and potentially negative carry.

 

To date the US yield curve hasn't yet indicated a full blown default cycle but the momentum remains worrying. The debate still rumbles on as to whether this cycle is different given the artificial nature of both ends of the major global yield curves. Although the last 4 US recessions have been preceded by an inverted yield curve, not all post WWII recessions saw an inversion beforehand but all saw a flattening of the curve (Figure 2). Maybe we won't see an inversion this time round prior to the next recession due to the extremely low Fed funds rate.

 

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Or maybe it is all a matter of how one looks at the yield curve: recall that as we showed 3 months ago using a BofA adjustment to the OIS curve to factor in the Fed's interventions, the curve is already inverted:

Applying our methodology to the OIS curve, we found that the adjusted 3m5s OIS curve at -30bp is already inverted. This suggests that the curve already could be priced for a recession (Chart 12). Granted, our methodology signaled a false alarm in 2012 when the curve was also inverted but a recession did not follow (Chart 12). However, at that time the curve flattened to extreme levels because of the forward guidance, an unprecedented event in the history of US monetary policy. In contrast, this time the curve flattened following the Fed hike, which looks more like a typical curve inversion episode. In fact, the Fed was hiking in all previous historical episodes where the curve inverted ahead of US recessions (Chart 8). From this point of view, the current curve flattening may be more worrisome.

In any event, it is now up to the Fed to pull an ECB -perhaps in the form of monetizing corporate debt and/or loans- and to find a way to open up credit channels, as otherwise it will be very difficult for cash strapped companies to avoid both a default cycle and the recession that - at least bast on historical data - will follow.