Investors are cheered by recent signs that the economy is starting to decelerate. Still, there remains a nagging worry that the Fed isn't quite finished with its monetary tightening. But a look at the corporate bond market suggests that the Fed is done with its task. Real corporate bond yields are at levels that in the past have never failed to decelerate the economy, corporate credit downgrades now outnumber upgrades, and the junk-bond market default rate is rising. Together, these factors indicate that the Fed's tightening campaign may already be nearing an end.
The turmoil in the $600 billion junk-bond market is especially telling--and critical. That market is a vital source of funds for marginal, more speculative companies. These debt-laden borrowers are particularly sensitive to subtle swings in the economic cycle. For instance, a signal that lenders are anticipating good economic times is when junk-bond yields come down and new high-yield issue volume soars.
MONEY BACK. On the other hand, when fixed-income investors expect the economy to weaken, junk-bond yields skyrocket, and new-issue activity plummets. After all, junk-bond companies struggle to meet their steep debt payments when the economy slows, and investors become increasingly nervous about getting their money back.
Small wonder Greenspan says he watches the high-yield market closely. Indeed, when discussing monetary policy and BBB-rated corporate-bond yields during his most recent biannual Humphrey-Hawkins testimony before Congress, Greenspan noted that "real long-term rates will at some point be high enough to finally balance demand with supply at the economy's potential in both the financial and product markets."
The Fed may have already reached that inflection point. The yield on junk bonds is over 10%, after adjusting for inflation--up more than two percentage points since the Fed began raising rates on June 30, 1999. "The junk-bond market is sending a message that investors believe the economy will slow substantially next year," says Mark Zandi, economist at Regional Financial Associates Inc. "This is what the Fed has been hoping would happen for some time."
The yield surge explains a sharp drop in new speculative-grade bond issues. New issues of domestic junk bonds are down 73% year-over-year during the January-April period, according to John Lonski, senior economist at Moody's Investors Service. In April, the total amount of junk-bond issuance was a measly $960 million--about half what it was at the nadir of the late 1998 global financial crisis. "Greenspan says he doesn't like to see a credit crunch," says Mark Vaselkiv, president of T. Rowe Price High Yield Fund. "You are seeing a credit crunch in the high-yield market already."
Of course, other factors beside inhospitable creditors are pushing up junk-bond yields. That market doubled in size over the past several years, and the huge increase in supply eventually satiated demand. The junk-bond market also funded many telecommunications, cable, and entertainment companies in recent years. During the first quarter, telecommunications paper accounted for almost 58% of all high-yield issuance, according to Martin S. Fridson, chief high-yield strategist at Merrill Lynch. The nearly 24% drop in the tech-laden Nasdaq since its March high has even enveloped the junk-bond market.
SCARCITY? Still, it pays to heed high-yield debt data. The collapse of the junk-bond market in 1989 was a harbinger of the economic turmoil and recession of the early 1990s. Indeed, the yield spread between junk bonds and Treasuries is now at recession levels. To be sure, some economists argue that the spread has widened because the U.S. government is buying back its long-term debt, which puts downward pressure on long-term Treasury yields.
But that doesn't explain the rise in junk-bond interest rates. "The widening of spreads has mostly to do with the Fed tightening monetary policy and less from the scarcity of Treasuries," says Scott Grannis, an economist at Western Asset Management, which has more than $65 billion in bonds.
The good news in all this? The Fed's tightening campaign could end sooner than expected. The bad news is that investors are now anticipating an economic slowdown. And that's not very good overall.
Read Farrell's Sound Money column each week at www.businessweek.com/today.htm