There Will Be Warnings

This post is a slightly-modified excerpt from a TSI commentary published about three weeks ago. Not much has changed in the meantime.

If you rely on the mainstream financial press for your information then you could be forgiven for believing that financial crises happen with no warning. However, there are always warnings if you know where to look.

Here are four leading indicators of financial stress and/or economic confidence that are both easy to monitor and worth monitoring. It’s likely that all four of these indicators will issue timely warnings prior to the next financial crisis and a virtual certainty that at least two of them will.

1) The yield curve, as depicted on the following chart by the 10yr-2yr yield spread.

As explained in many previous commentaries, the yield curve ‘flattening’ to an extreme and then beginning to steepen warns that an inflation-fueled boom has begun to unravel. For example, the yield curve reached its maximum ‘flatness’ in November-2006 and provided clear evidence of a reversal in June-2007. That was the financial crisis warning. By August of 2007 the ‘steepening’ trend was accelerating.

The yield curve’s current situation looks more like Q4-2006 than Q3-2007. It is nothing like 2008.

2) Credit spreads, as depicted on the following chart by the difference between the Merrill Lynch US High Yield Master II Effective Yield and the yield on the 10-Year T-Note.

Credit spreads start to widen, indicating a decline in economic confidence and/or a rise in the perceived risk of default at the junk end of the debt market, well before a recession or crisis. For example, evidence of a new widening trend in credit spreads emerged in July-2007 and by November-2007 it was very obvious that trouble was brewing.

Note that when it comes to warning of a coming crisis, credit spreads are far more likely to generate a false positive signal than a false negative signal, that is, they are far more likely to cry wolf when there’s no wolf than to remain silent when there is a wolf.