The current strains in the banking system demonstrated by the collapse of Silicon Valley and Signature banks have profoundly changed the outlook for markets.
Many market players had been debating when central banks would pause and stop raising short-term rates.
Now, that debate is between those who believe rates are on hold and those who believe rates will soon be forced down. This is why bond yields plummeted so quickly.
It is too early to predict if this crisis will spiral out of control. One thing is almost always and forever true: When central bankers raise short-term rates dramatically and hastily, the banking system will be stressed.
Many economists, market analysts and traders are expecting a recession in the near future, as interest rates have increased dramatically from all-time lows and the gold standard of indicators, the yield curve, has become sharply inverted. This month, two-year U.S. Treasury notes have been trading the most above 10-year bonds in more than four decades.
Given these economic clouds, it’s rather perplexing that the extra yield offered on corporate bonds relative to government issues, which are generally perceived as the safer investment option, has been so slim. Although spreads have widened over the past week, they are narrow compared with other periods of economic slowdowns or financial stress.
Yield curve inversions over the past half-century have coincided with a sharp widening in corporate bond spreads. This is true for both investment-grade and high-yield debt. And yet, spreads remain narrow.
What’s behind it?
Perhaps it has something to do with interest rates having gone up so much that overall yields on corporate bonds are simply already attractive enough to appeal to buyers. They are at levels not seen in well over a decade in absolute terms, before factoring in the impact of inflation.
On average right now, investment-grade bonds are averaging 5.3 per cent, while high yield is 8.8 per cent.
Maybe the corporate debt market has it right and the yield curve is wrong in signalling tough economic times ahead. It should also be pointed out that although the yield curve works well in predicting a recession, it does a poorer job forecasting the severity of a downturn.
Up until the start of this latest crisis, the inversion of the yield curve also wasn’t accompanied by something that is usually seen at times of economic distress: an explosion in stock market volatility. It also wasn’t accompanied by a period in which central bankers have increased short-term rates to levels significantly above current inflation.
Meanwhile, as many politicians and those whose income depends on keeping people invested in the stock market are quick to point out, unemployment is extraordinarily low by historic standards.
Before jumping to any conclusion that the yield curve has sent a false recessionary signal, however, this crucial fact needs to be pointed out: An inverted yield curve is truly a leading indicator, not a coincident or lagging one. Just because two-year yields are trading above the yield on a 10-year note does not mean that the downturn has begun.
Unemployment is a lagging indicator and tends not to increase until a downturn is well under way. In fact, the unemployment rate tends to keep rising even as a new economic boom begins.
Companies do not follow spreads on a minute-by-minute basis and fire half their staff after the yield curve inverts. Typically, inversions precede recessions by one to two years or even slightly longer. In our present situation, the U.S. Treasury 10-year to two-year spread did not truly and significantly invert until July 6, 2022, using the Fed’s data. Therefore, expecting an official recession right now is premature.
Furthermore, because of the lag in GDP data, the economy typically is in a recession for a couple of quarters before it is officially declared. Case in point: The recession of 2000 was barely noticeable at the time, and the economy had returned to growth before the downturn was official.
Given the economic reality that exists at present, I would assess a very low probability of the “no landing” narrative – avoiding a technical recession altogether – coming to pass. It is based on a combination of confirmation bias, the desire for client retention and wishful thinking on the part of those supporting this view. Therefore, corporate bonds are trading at prices that are high relative to current risks. As yields moved inversely, that means they are low in relation to government bonds.
Those yields will likely see greater spreads eventually to government bonds.
If and when they do widen out, it will provide a tremendous opportunity to bravely buy these issues, as investors will be in panic mode and will be dumping their positions at low prices.
Corporate spread widening may hit a tipping point caused by some sort of major, systemwide liquidity crisis as investors flee to the safety of Treasuries or a deterioration of corporate earnings due to poor economic conditions or unexpected bankruptcies.
Every time I have seen corporate spreads blow out, it provided a tremendous buying opportunity.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed-income and asset-mix strategy. He is a former lead manager of Royal Bank’s main bond fund.