What are US credit markets telling us about the economy?
Some of our readers will know that a classic Treasury-market recession warning has been flashing since July — 2-year Treasuries are yielding more than 10-year notes. But corporate bond markets give the impression that credit investors are not especially alarmed about this. The long-dated Treasury TLT is down 24 per cent, compared to the investment-grade corporate LQD and junk-bond HYG, down 17 per cent and 13 per cent, respectively.
That means companies with worse credit ratings are seeing their debt outperform this year. You would expect those bonds to sell off if a recession is looming, right? Does that mean all the talk about recession is overblown?
Not exactly.
First, we should say that Treasury yield curve inversions are not magic (even if they can be eerie). The simplest reason for two-year yields to rise above 10-year yields is that investors expect the Fed to cut rates at some point between 2024 and 2032. That sounds like a reasonable expectation to have after Fed Chair Jay Powell doubled down on his hawkish tone at Jackson Hole last week. If the Fed is going to keep raising rates for a while, why buy high-quality bonds? High-quality bonds are hurt most by rate increases.
So the Treasury market isn’t really conflicting with the corporate bond market — if it takes two years for a recession to cause the Fed to cut rates, there’s still a couple of years’ worth of yield to be eked out of corporate debt. And junk bonds yield more than 8%.
In any event, when or if a recession does arrive, Morgan Stanley believes the high-yield bond market’s response will look less extreme. In a note this week, the bank argues that high-yield bond market spreads should widen less than normal in a recession: just 700bp instead of 800bp or 850bp. We will let the strategists explain:
In other words, 1) the market on aggregate has higher credit quality — or at higher ratings, at least — than it did in the past 2) more owners of high-yield bonds have a secured claim on company assets, and 3) prices go down when yields go up, so prices have already gone down a bit. We here at Alphaville love bond-market maths.
Instead of high-yield bonds, the bank’s strategists say that problems will probably show up in high-yield loans, where interest rates float, and credit quality has deteriorated quite a lot in the past several years. (Investors tend to pile into loans before interest rates go up, allowing more froth in that corner of the market — the CLO machine has proven a relatively healthy source of demand too.) They write:
This is not an especially tradeable view, regrettably, because most leveraged loans are not standardised. In fact, until surprisingly recently, fax machines were not totally unfamiliar to leveraged-loan back-office operations:
The good news is the canary is still singing. For now.
Elsewhere on Tuesday . . .
— Over the bank holiday the Sunday Times published an op-ed titled “Drinking recycled sewage ‘is the future’” and encouraging people to be “less squeamish.” (Sunday Times $, BBC)
— The IMF has approved $1.1bn for Pakistan. (FT)
— The making of ‘bad gentry’ after the abolition of the civil service exam in China, 1902-1911 (The Journal of Economic History, v Phenomenal World)
— Zach Carter with a post on the real student debt debate, and a piece about the history of debt jubilees. (Substack, Slate)
— Peloton has delayed its 10-K filing. (SEC filing h/t Bloomberg $)
— Former Alphavillain Kate Mackenzie writes on climate diplomacy and finance for Phenomenal World.
— Petrodollars: Where are the surpluses? Part 1 (Exante Data, $)
