Here’s What "Degradation of Credit Standards" Suggests for U.S. Economy

Across the board, bond markets are flashing advance warning

The old saying about "a thief in the night" applies to deflation. It arrives when almost no one expects it. Learn why the onset of deflation might be a lot closer than most observers realize.

How many economic commentators have you heard recently who expressed worry about the prospects of deflation?

Right, perhaps one here and there, but the vast majority are silent on the subject.

This brings to mind what Robert Prechter's Conquer the Crash (2002) said:

Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely.

Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.

Those words certainly applied four years later, when U.S. home prices topped in 2006 and then went into a tailspin that continued through early 2012. Of course, as we all know now, one of the main culprits was the proliferation of subprime mortgages, or widespread lending to "weak borrowers." Also touching on what Conquer the Crash said, this reckless lending reached a zenith "near the end of a major expansion" when almost no one was worried about default.

This brings us to 2018, a year when a financial uptrend has stretched approximately twice as long as the one that culminated in the October 2007 stock market top.

No wonder we have this from CNBC (April 12):

Subprime mortgages make a comeback—with a new name and soaring demand

The subprime mortgage industry vanished after the Great Recession but is now being reinvented as the nonprime market.

No wonder we've had this news about the actions of a major financial firm (Financial Times, May 1):

Blackstone accelerates into subprime car loans

And, no wonder relatively few expect deflation.

Here's an April 15, 2018 Wall Street Journal headline:

Fed Officials Dispel Specter of Deflation

The Elliott Wave Financial Forecast, a monthly publication co-edited by Elliott Wave International’s Chief Market Analyst Steve Hochberg and his colleague Pete Kendall, provides our insight. This chart and commentary is from the July 2018 issue:

Worst Covenants Ever

Prevailing optimism has led to the degradation of credit standards. Approximately 80% of all new U.S. bond issuance is designated as Covenant-lite, meaning that these bonds do not require the usual performance standards of issuing companies, which would theoretically provide a cushion against the potential for default. According to long-time bond analyst Marty Fridson, the covenant quality on U.S. junk bonds in May was the weakest on record. … [Emphasis added.]

This toxic brew of extreme optimism and deteriorating credit standards places nearly all bonds at high risk of price depreciation.

In other words, again, the onset of deflation may be a lot closer than most observers realize.

Now is the time to prepare.

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