Credit Markets Didn't Get the Recession Memo

Recession fears crescendoed after the Institute for Supply Management said Tuesday that its monthly index of U.S. manufacturing fell below the dividing line that separates expansion from contraction for the first time since 2016. Stocks fell and government bonds rallied as traders priced in greater amounts of monetary policy easing by the Federal Reserve before the year is out. Credit markets, however, were unusually sanguine in what may be the ultimate referendum on the state of the economy.

Yields on U.S. corporate bonds barely budged relative to Treasuries, keeping spreads below their widest levels of the year despite worries that a sharp economic contraction may be looming. Not only that: A flood of new issuance hit the market Tuesday, in what Bloomberg News called one of the busiest days ever for debt sales. Sure, the corporate bond market has benefited from the “hunt for yield,” with rates on government debt securities at or near all-time lows – and even below zero in many places such as Europe and Japan. Some of that demand may be masking recession worries. But credit traders generally have excellent insights into the health of corporate balance sheets. And here, things look pretty good. Moody’s sees the global default rate at just 2.4% through May 2020, below the historical average of 4.2% since 1983. For those wary of trusting credit-ratings firm after their dismal performance heading into the financial crisis a decade ago, there’s always the credit-market metric advocated by Nobel laureate and Janus Henderson Investors Chief Investment Strategist Myron Scholes and his colleague Ash Alankar. Rather than taking cues from the Treasury market’s yield curve, which has inverted in a traditional sign that a recession is looming, they believe a better indicator is the credit market’s yield curve. More specifically, they recommend looking at the difference in the credit spread between short- and long-dated U.S. corporate bonds.