The Treasury market sent a recession warning signal heard ’round the world last week. The rest of the bond market appears to be ignoring it.
The Treasury yield curve inverted Friday as the yield on the benchmark 10-year note dropped below that of the three-month bill. Investors’ willingness to accept a lower yield on a longer, and thus riskier, fixed-income instrument classically has been a harbinger of an economic downturn. They implicitly anticipate the Federal Reserve will lower interest rates in response to future weakness, and so they seek to lock in yields before they fall further.
To one who has been covering this stuff for more years than I care to mention (“The Yin and Yang of the Yield Curve” was a favorite column headline back in the 1990s), this sudden attention to the subject is a bit bemusing. That also makes me old enough utter the phrase “this time is different” only with trepidation. But there are significant differences now.
In particular, the corporate bond market is sending a different message than the Treasury market. And the Treasury market—the most liquid and active securities market on the planet—is being affected by technical factors domestically and internationally.
Quite simply, corporate credits are not showing the same concerns about economic risks. That’s indicated by the shrinkage of the risk premiums on lower-grade bonds over higher-grade ones, another redoubtable barometer of economic worries. So this alarm bell is not going off.
“Corporate spreads are extraordinarily narrow,” says Dan Fuss, vice chairman of Loomis Sayles, who has been managing corporate bonds for six decades. Those tight spreads are typically associated with fixed-income investors’ willingness to reach for riskier credits in their quest for higher yields—rather than their desire to batten down the hatches in anticipation of coming economic turbulence.
The corporate credit market signaled a mild economic slowing in the fourth quarter, but that since has partially reversed, according to David Ranson, who heads HCWE & Co. (formerly known as H.C. Wainwright & Co. Economics). His favored indicator is the relationship of Moody’s Aaa-rated (top-grade) corporate bonds to Baa-rated (lower-investment-grade) corporate credits. The spread between the two increased only one-third as much in the fourth quarter as would be consistent with an approaching recession. Since the beginning of the year, however, the spread has contracted, indicating diminished economic risks.
Similarly, economist Stan Shipley at Evercore ISI, in client note Tuesday, ticked off several credit-market indicators that contradicted the Treasury yield curve’s recession call. They include still-upward-sloping yield curves in the U.S. municipal, corporate, and mortgage-backed securities markets, as well as in international bond markets (where there were some $10 trillion of bonds with negative yields as of Tuesday); short-term interest rates that are not elevated, relative to inflation; and low Baa credit spreads, consistent with Ranson’s point.
Part of the latter indicator relates to market dynamics, observes Fuss of Loomis Sayles. There is a strong bid for BBB credits (the S&P equivalent of Moody’s Baa rating), such as those of General Electric (GE); these are vulnerable to being downgraded to junk but are focused on repairing their balance sheets to prevent such an ignominious fate. The private bond market and the leveraged-loan market have been strong and have been ready sources of cash for borrowers, also signs that corporate-credit investors are less worried about the economy than missing out.
Finally, there are technical factors at work in the Treasury market that may be affecting the shape of the yield curve. The spread that caught everybody’s attention was that of the three-month bill versus the 10-year note, which turned negative briefly last Friday and triggered the sirens warning of recession. By Wednesday morning, the curve became even more inverted, with the three-month bill at 2.464% and the benchmark note at 2.370%, following a drop in German Bund yields further into negative territory.
Part of the U.S. curve’s inversion may reflect the surfeit of short-term bills issued by the Treasury. According to JPMorgan, since the end of January there has been a $170 billion increase in the supply of bills, or some 7%. This is largely seasonal, in part to fund tax refunds. As a result, T-bill rates have increased relative to the short-term rates pegged by the Fed, the bank’s Treasury analysts write.
But once the dreaded April 15 tax-filing deadline comes, the Treasury is likely to pay down some of those short-term bills by an estimated $195 billion, or $71 billion greater than the drop-off last year, the JPM economists write in a client note.
That said, the federal-funds futures market thinks the odds of a Fed rate cut by year-end are better than 3-to-1 (a 76.3% probability, to be exact, as of Wednesday morning, according to the CME FedWatch site). Further reflecting those rate-cut expectations, Tuesday’s auction of two-year notes drew strong bidding at a high yield of 2.261%, near the bottom of the central bank’s fed-funds target range of 2.25%-2.50%, and nearly 25 basis points (one-quarter percentage point) less than the three-month bill. By Wednesday, the two-year yield had fallen further, to 2.206%.
But the low risk premiums on lower-investment-grade and speculative-grade debt suggest corporate-credit investors don’t see an economic downturn ahead. HCWE’s Ranson contends the private markets have become far deeper and sophisticated and are a better barometer than government securities dominated by central banks.
While every recession has been preceded by an inverted yield curve, not every yield curve inversion has led to a recession. The corporate credit market appears to be betting on the latter outcome.
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