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This little-known indicator has something encouraging to say about the economy and markets

Economic doomsayers are obsessing over the state of the yield curve. For a better guide to whether a recession lies ahead, they may want to consider a less well-known indicator.

A measure known as the excess bond premium (EBP) gauges how cheery lenders are about the state of the economy. Right now, the EBP is strikingly upbeat. Its most recent reading indicates only an 11.5-per-cent chance of a U.S. recession over the next year.

The EBP’s sunny outlook stands in stark contrast to all the dark forebodings around the yield curve. That curve is essentially a way to represent how short-term interest rates compare with longer-term rates. As any home buyer knows, you usually have to pay considerably higher rates to borrow money for longer periods than for shorter periods.

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In recent months, though, the yield curve has flattened and is now only a fraction of a percentage point from inverting – that is, reversing its normal pattern and reaching a point where it will cost more to borrow money for two years than for 10 years.

Such inversions have occurred with ominous regularity before past U.S. recessions, so yield curve watching has recently become the favourite hobby of pundits, policy-makers and economists. If the curve does invert in coming days, many investors will take it as a warning bell and start scurrying for cover.

But before packing your own bags, you may want to consider the more positive message delivered by the EBP. This indicator is nowhere near as flashy as its yield-curve cousin, but is arguably more useful in today’s economy.

It was developed by Simon Gilchrist of Boston University and Egon Zakrajsek of the U.S. Federal Reserve Board. In a 2012 paper, they explored the credit spreads on bonds from U.S. non-financial corporations. These credit spreads are the extra return that investors demand to hold corporate bonds instead of safer government bonds of the same maturity.

In theory, the spread serves as a buffer against the risk of a borrower defaulting. But a portion of it appears to be over and above what would be called for simply to offset the usual risk of default. This excess bond premium can be seen as a measure of investors' attitudes toward corporate risk. In effect, it’s a gauge of how optimistic investors are about the economic outlook. If they’re happy about what they see ahead, the EBP will remain low. Conversely, growing anxiety about what lies ahead will cause the EBP to surge.

Since 1970, the EBP has jumped ahead of most U.S. recessions. “The EBP provides a timely and useful leading indicator of economic downturns,” according to a note from the Federal Reserve. A similar approach appears to work in other countries as well. “The Canadian EBP is highly informative about the Canadian growth outlook,” the Bank of Canada concluded earlier this year.

To be sure, the EBP is not perfect. In 2002, the U.S. EBP surged following an outburst of corporate accounting scandals. It also spiked in early 2016 as a slowdown in China roiled world markets. In both cases, no recession followed. For the most part, though, the EBP’s track record of predicting U.S. recessions is impressive.

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Investors may want to pay particular attention to the EBP right now because the time-honoured yield curve signal could be less reliable than it has been in the past. One reason? Aggressive bond-buying by global central banks in recent years has put a lid on longer-term borrowing costs, making it easier for the curve to invert.

In addition, there’s the problem of how one defines the yield curve. While most attention has focused on the difference between two-year and 10-year Treasury yields, the Federal Reserve Bank of San Francisco recently pointed out that the gap between three-month and 10-year yields has historically been an even better recession indicator. That latter measure of the yield curve is in no danger of inverting any time soon.

Investors who want an alternative view should keep a close eye on the EBP. The Federal Reserve calculates the premium and publishes regular monthly updates.

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