US credit market warns about recession

RISING RISK PREMIUMS ON CORPORATE BONDS SINCE FEBRUARY MAY BE AN OMEN, ANALYSTS BELIEVE

Areliable bond market indicator may be waving the flag that a US recession is coming, market watchers said. Risk premiums on investment-grade corporate bonds over comparable Treasuries have been rising since February, approaching levels that are catching the attention of some fund managers and analysts.

“People are talking about the yield curve as a predictor of recessions. Credit spreads are the other element that’s a pretty big tell,” said Gene Tannuzzo, senior portfolio manager at Columbia Threadneedle Investments.

With investors watching for signs of whether the end is near for the second longest US expansion on record, this move in the $9 trillion (Dh33.05 trillion) corporate bond market bears watching.

The world’s biggest economy still seems healthy by many measures: low unemployment, strong exports, a resilient housing market and sky-high consumer and business confidence.

Still, escalating global trade tensions have some investors worried. Also, US inflation remains stubbornly low, removing pricing power from businesses, while benchmark interest rates are rising. Also, the federal deficit is ballooning after a massive tax cut hurt revenues.

Some investors are nervous that the yield curve has flattened, with yields on long-term bonds getting close to those of short-term government debt. But the curve has not inverted, a situation when long-term yields go below those of short-term debt, seen as the most reliable recession indicator.

‘Weird recession’

“We have had a weird recovery. If you have a weird recovery, you might have a weird recession,” said Jim Paulsen, chief investment strategist at the Leuthold Group in Minneapolis. Paulsen noted that risk premiums or spreads on Baa-rated corporate bonds over Treasuries increased to 2 per cent this month based on data from Moody’s Investors Services. This milestone was reached either during or just before six of the past seven US recessions since 1970.

In February, spreads on the riskiest investment-grade bonds, based on Moody’s rating scale, averaged 1.65 per cent, the lowest in more than a decade.

Dallas Fed President Robert Kaplan told Reuters in an interview on Friday that while credit conditions are benign, they can deteriorate quickly.

“Credit spreads are reasonably tight, but that can change rapidly,” he said.

US corporations are sitting on about $2 trillion of cash and still can still borrow easily even as the Fed has been raising short-term interest rates since December 2015. With the economy humming along, bolstered by last year’s federal tax overhaul, S&P 500 companies are forecast to ring up a robust 21 per cent rise in second-quarter earnings, according to Thomson Reuters data.

While wider credit spreads and a flattening yield curve are red flags, some fund managers reckon a solid US economy and a cautious Federal Reserve should keep a recession away for at least another year. “I think it’s premature that the credit market is sending any kind of cautionary signal,” said John Bellows, portfolio manager at Western Asset Management Co in California.