C.J. Lawrence Weekly – Tight Bond Spreads Suggest Recession is not Imminent
Last week’s economic data releases were market moving events. Traders’ algorithms were spring loaded and poised to react to any signal suggesting the economy was moving in one direction or the other. On Wednesday, before the open, the Department of Labor released its Initial Jobless Claims report that came in slightly higher (negative) than expectations. That put the market on edge for the eagerly awaited ISM Non-Manufacturing report. Earlier in the week the soft ISM Manufacturing report had sparked a market sell-off, pushing stocks down ~3.0% in the two days following the release. So with the manufacturing economy struggling, all eyes were trained on consumer related metrics to guage whether the U.S. economy’s Atlas was stumbling. When the ISM Non-Manufacturing report came in below expectations, the market reaction was swift. Within sixty seconds of the report’s release the S&P 500 Index was down 0.8%, or almost $200 billion in dollar value. By 10:09am the Index had lost 1.2%, or almost $313 billion of value, all on the back of one data point! Remarkably, stocks steadied and recovered throughout the day on Thursday, ending the session up 0.8%. The price action highlighted a familiar pattern around recent data events whereby there is a significant market reaction, followed by some digestion and interpretation, and then some recalibration.
As the recession debate escalates, stock market jitters and volatility may persist. But the corporate bond market looks to be keeping its cool. Typically, in recessionary periods, and in periods leading up to recessions, the spread between corporate bond yields and U.S. treasury bond yields widens as investors demand more reward for their risk. To date, spead widening has been limited. Corporate bonds rated BBB by Standard and Poors, which comprise the the bulk of all rated bonds across the ratings spectrum, are holding their yields versus treasuries. This tranche, the value of which eclipses the entire aggregate value of all speculative grade tranches, has experienced some spread widening since 2017 but continues to hold below historical average spreads. The message from the corporate bond market seems to be that while the economy is slowing the likelihood of financial stress, downgrades, and defaults is low and that the odds for a near-term recession are remote.
The same message can be derived from the “junk bond” market. Junk bonds, or bonds given ratings considered speculative, are considered the most economically sensitive. CCC rated bonds (by Standard and Poors) are at the bottom of the ratings scale and companies with bonds in this category are often the first to experience financial stress when the economy slows. Perhaps historically low borrowing costs are propping up some issuers even as the economy loses steam, but the bond market doesn’t look worried. CCC spreads have been creeping higher, but are still comfortably below historical averages. With a high concentration of oil and gas industry borrowers, this category is also sensitive to the direction of commodity prices, which may account for some of the recent spread widening. The direction of absolute U.S. Treasury bond yields will offer important insights into the strength of the U.S. economy, the direction of inflation, and investor risk appetite. But yield spreads are another useful tool in gauging the health of U.S. rated companies and their risks related to the direction of the U.S. economy. So far those signals are not flashing any meaningful warnings.