A reliable bond market indicator may be waving the flag that a U.S. recession is coming, market watchers said, and it is not the flattening yield curve.
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 predicter of recessions. Credit spreads are the other element that's a pretty big tell," said Gene Tannuzzo, senior portfolio manager at Columbia Threadneedle Investments in Minneapolis.
With investors watching for signs of whether the end is near for the second longest U.S. expansion on record, this move in the $9 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, U.S. 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 in 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.
"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 percent this month based on data from Moody's Investors Services. This milestone was reached either during or just before six of the past seven U.S. recessions since 1970.
In February, spreads on the riskiest investment-grade bonds, based on Moody's rating scale, averaged 1.65 percent, 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.
POSSIBLE TROUBLE BREWING
U.S. 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 percent rise in second-quarter earnings, according to Thomson Reuters data.
Yet corporate bonds have performed poorly this year as fears about a trade war have overshadowed investor optimism from tax cuts and lighter regulations. Heavy issuance and reduced foreign appetite have also bogged down the sector, analysts said.
Looser lending standards have nudged default rates slightly higher, although they are still hovering near historic lows.
"Poorly performing investment grade bonds and weakened speculative grade covenants have focused investors’ minds on the corporate sector as a source of recession risk," Credit Suisse economists wrote in a research report this week.
While credit market conditions have not reached alarming levels, "potentially dangerous dynamics are brewing," they wrote. Possible warning signs they are watching for would include abrupt changes in short- and long-dated interest rates and a widening in credit spreads, they said.
While wider credit spreads and a flattening yield curve are red flags, some fund managers reckon a solid U.S. 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 Pasadena, California.
The U.S. economy was growing at nearly a 4 percent pace in the second quarter, according to the Atlanta Fed's forecast model, so Bellows said it can absorb gradual rate increases from the Fed.
"Right now, growth in the United States has been fairly good with surprises on the upside lately," he said. "Hikes from the Fed at the current pace are appropriately cautious and won't be disruptive."
Policy makers signaled the U.S. central bank may consider raising overnight borrowing costs twice more this year. Analysts and investors said they will keep a close watch on how the corporate bond market reacts to policy and economic developments.
"This is not the end-all of recession indicators. It's just one," said Leuthold's Paulsen. "It does make me worry."
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