Economics in the orthodox version has it entirely backwards. If that wasn’t apparent in the last cycle, it is becoming far more so once again. This descent into math is not limited to econometrics, as it says a lot about the state of popular perception more generally. Computer models and statistics are given the moniker of “science” which is wielded as something like a declaration of objective truth and the end of debate (and really further examination). It is no such thing; statistics are just as biased as any other format for understanding complexity. But what statistical domination has done has been to actually remove the true methods of science; meaning observation.

After the violent selloff all across the world in this month, there was bound to be a rebound in everything including oil which has been a driving factor (confusing those clinging to their math). This morning’s bounce has been attributed to hopes and whispers of more central bank “stimulus” (I’ll get to that later) which was entirely expected given the state of the world. And isolated as that seems to make Janet Yellen and her FOMC in a “what were they thinking” sense, economists instead turn that entirely around as if it is markets that have it all wrong.

“We cannot rule out a recession in the next year. Accidents will happen, and we are concerned about the lack of policy ammunition to deal with a major shock,” economists Ethan Harris and Emanuella Enenajor said in a note on Friday.

 

“However, when markets are in such a fragile state there is a temptation to lose sight of the economic fundamentals. To us, the economy is okay and recession risks are low,” they said.

In other words, their centralized, agglomerated models are more real than decentralized and observed market prices; the recovery is still being spit out of the regressions, so economists really don’t know why markets would be so unsettled. This is backwards in every possible manner. In the scientific sense, economists demand that we completely set aside all observation (the basis of all science) to have only faith (not science) in subjective math that at the very start encodes “stimulus” as if it were that (GIGO); worse, we are to have faith in the models after the models haven’t been right about anything for at least a decade and really, if you are being honest, ever.

It is also backward in raw economic terms, as markets always lead. The popular perception assigns stocks that role in discounting, but that hasn’t been the case for as long as the monetary models have been projecting monetary policy (imagine that). Funding markets became irregular before credit markets in late 2006 and early 2007, while stocks were still shooting up to their then-record as late as October 2007 – only weeks before the Great Recession started and two months after the eurodollar standard effectively died.

With funding markets much harder to grasp and comprehend (though it is hard to ignore how the world’s currencies all seem to want to crash), it isn’t surprising that it takes the greater visibility of credit to offer more convincing evidence. The relationship between the economy and credit is, after all, relatively straight forward in a way global eurodollar liquidity never will be. The credit cycle, in a monetized setting of the financialized economy, is the leading factor. If the credit cycle were to turn then we should expect the economy to turn.

That was the great question in the summer of 2014 when some unusual market activity suddenly appeared. In mid-August of that year, the New York Times published a remarkably balanced article on the spark of worry that had been lighted then. The high yield segment had been in overdrive for so long, “everyone” knew that it was likely overdone but what was less clear was by how much and whether that was the turning point.

Tad Rivelle, fixed-income chief investment officer at the fund management company TCW, noted that there was more at stake than just the direction of bond prices.

 

“The credit cycle is actually the driver of the overall business cycle,” he said. “The durability of the economic expansion, such as it is, is largely dependent on the capital markets and the willingness of the junk bond market to continue to finance more marginal borrowers and more marginal deals. For clues for how late we are in the cycle, look no further than the high-yield market.”

I believe the only reason that opinion was placed in the piece was because at that point nobody really believed it was actually happening; the economy seemed just too good to begin thinking about already (“already” in the sense of QE taper not time which had already dragged years beyond what should have occurred) a cycle turn. Indeed, that was the sentiment expressed a few paragraphs later which leaned heavily on the mainstream, orthodox assessment:

Doug Forsyth, fixed-income chief investment officer at Allianz Global Investors, recently issued a note to investors highlighting his “prolonged positive outlook for the high-yield bond market.” Low interest rates and modest economic growth provide a benign backdrop, in his opinion. Companies have a lot of cash to work with, and relative indebtedness and interest costs “are near, or better than, levels seen in the past 25 years.”

 

Michael Contopoulos, head of high yield strategy for Bank of America Merrill Lynch Global Research, offered a similar perspective. Amid improving economic data, weak wage inflation, a dovish Federal Reserve and a low default rate, he recently wrote, “the case for high yield remains compelling.” [emphasis added]

It amounts to circular reasoning; the economy is good, therefore high yield must still be in the same credit cycle, and if the credit cycle hasn’t turned that means the economy is good. That has been the arrangement for economists and their outlook for the past eighteen months since that story was published. For investors, that has not been the case as circular logic doesn’t apply to maintaining leveraged credit (and funding) positions. The risks the high yield market are signaling that very credit cycle turn.

ABOOK Jan 2016 Credit Cycle Lev Loan 100 ABOOK Jan 2016 Credit Cycle BofAML CCC

There is left little doubt about it at this point, particularly when you see that high yield prices and yields are more and more equivalent to 2008 – and the worst parts, no less. That does not necessarily mean we are plunging toward a revisit of the Great Recession, only that the probability of the credit cycle turn is now closer to 100% and that the market-driven process is now about determining how much economic damage the turn in cycle might produce. Thus, we cannot rule out another Great Recession, either.

ABOOK Jan 2016 Credit Cycle Lev Loan 100d ABOOK Jan 2016 Credit Cycle BofAML CCCb

A year ago, economists were quick to emphasize that there was no chance of any recession at any point, “transitory” as all these problems would no doubt turn out. Now, even grudgingly admitting that there are deeper and more intractable imbalances, still the models rule and “stimulus” is all that mattered or might matter. Again, junk bonds are telling us that the credit cycle has already turned; what it (and we) is now trying to determine is what might be the worst case in that scenario given observed conditions at this moment overall; not just energy, not just manufacturing, but everywhere.

It would be a compelling economic marker if it were just junk bonds, but it isn’t. Commodities and currencies (with bonds you get all the letters in FICC) are perhaps even further into the worst case spectrum of possibilities. And through it all, central bankers are still looking for inflation; it’s right around the corner, only this time that increasingly suggests the next cycle.

ABOOK Jan 2016 US Problems 5yr5yrABOOK Oct 2015 FOMC Circular