One of them is wrong. Watch out for it to snap in an ugly manner.
When the economy goes into a downturn, even a plain-vanilla recession or
near-recession and not a crisis, junk bonds behave badly. This is because
over-indebted companies with iffy cash flows – those are the ones that are
junk rated – begin to buckle.
In a downturn, they have no wiggle room; some default on their debts and
file for bankruptcy, stockholders get shafted, and bondholders take big
losses. Everyone knows the drill. Fear of this happening spreads throughout
the junk-bond market. Junk-bond prices fall and yields surge.
Borrowing costs for some riskier companies will shoot through the roof,
which will cause them to be unable to borrow new money to pay off existing
creditors, and they’ll default too. And these waves of defaults will scare
the market further. Investors want to be paid ever larger premiums over
Treasuries securities – which are considered free from credit risk. And the
difference in yield between junk bonds and Treasuries – the yield “spread” –
widens brutally.
Typically, in this scenario, Treasury yields fall, as Treasury securities
become more sought-after as haven, thus driving up Treasury prices. These
moves are typically backed by the expectations the Fed would cut rates, if it
isn’t already cutting rates.
In this downturn scenario, junk bond yields are surging while Treasury
yields are falling, and the spread between the two is blowing out.
For example, take the spread between the average yield at the riskiest end
of the junk-bond market, CCC-rated
and below (as tracked by the ICE BofAML US High Yield CCC or Below
Effective Yield index), and the equivalent Treasury yield:
- Before and into the 2001 recession, this spread doubled
from around 12 percentage points to 24 percentage points.
- During the Financial Crisis, this spread more than quintupled
from 7 percentage points in mid-2007 to 37 percentage points at the end
of 2008, as junk bonds essentially collapsed.
- During the oil bust, from July 2014 to February 2016 –
the US economy got uncomfortably close to a recession in late 2015 and
early 2016 – this spread tripled from 7 percentage points to over
20 percentage points.
And in today’s scenario?
Since December 24, the 10-year Treasury yield has dropped 50 basis points
(half a percentage point) and the yield curved sagged in the middle and
partially inverted. In many people’s minds, this is screaming “recession” in
every direction. Inverted-yield-curve-and-recession talk is now everywhere.
Wall Street pundits have been clamoring vociferously for a series of rate
cuts. And they have propagated the theory that the Fed has performed a
“U-Turn,” in response to the US economy heading into a recession.
And junk bond yields? CCC-and-below-rated yields should have soared in
this economic-slowdown scenario, they should have doubled, at a
minimum, given how much of a beating investors could expect to take during
the wave of defaults associated with a downturn, and how much in yield
investors would demand in return for taking that beating.
But the opposite happened. The average yield of CCC-and-below-rated bonds fell
from 13.7% on December 26 to 11.2% now.
And the spread between the average CCC-and-below-rated junk bond yield and
Treasury yields narrowed by two percentage points, from 11.1
percentage points on December 24 to 9.1 percentage points now.
There is no fear of an impending recession in the junk bond market. The
market is sanguine. It’s leisurely sorting through company-specific risks.
But the overall market has calmed down a lot from December 24. This
chart shows the spread between CCC-and-below-rated bonds and Treasuries:
So now, the Treasury market with its inverted yield curve and declining
yields on the long end is clamoring for rate cuts, and it’s acting as if a
recession were imminent or has already started. But the junk bond market is
acting as if it were a big boom party, and risks are just minor
company-specific issues, rather than overall economic issues.
But they cannot both be right. So what gives?
It could be that the junk bond market ignores the problems in the economy
– that it is completely oblivious to the impending downturn and the corporate
default wave that this would entail.
Or it could be that the Treasury market has gone nuts – that all this
clamoring for rate cuts and these proclamations of the Fed’s mythical
“U-Turn” (cutting rates and re-starting QE) has polluted investors’ minds.
Or it could be that international investors are spooked by developments in
China or Europe or whatever, and that they’re massively seeking US Treasuries
has haven from turbulence outside the US.
Or it could be whatever.
“Why” markets are doing what they’re doing – “Dow dropped 300 points because…”
– is just speculation. We rarely know with certainty “why” markets move in
certain ways. And that uncertainty – market participants disagreeing over the
direction – is what makes a market with buyers and sellers.
But if bond markets are seen as a predictor of the next downturn, then
either the junk bond market or the Treasury market is wrong.
If the junk bond market is wrong, it would be set up for a painful
reckoning.
But if the Treasury market – and the Treasury yield curve – is wrong,
there could be an ugly snap-back in longer-term Treasury yields, and related
interest rates, such as mortgage rates.
This sort of snap-back in Treasury yields happened in July-December 2016:
as recession fears faded, the 10-year yield jumped by over 1 percentage
point, from 1.37% to 2.6% — nearly doubling in less than six months.
So we can take our pick. But they can’t both be right.
Here’s the Fed introducing a new thingy about “patient” to tamp down
on the rate-cut clamorers on Wall Street. Read... My
Fancy-Schmancy “Fed Hawk-o-Meter.” And the Fed Says It’ll be “Patient” with
Rate Cuts, Even at “Low Inflation”
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