The Great Recession contained many lessons for investors, but one of the most important is something that market insiders have always known: you must watch the bond market closely.
That disaster was a credit crisis, so it was only logical that the first signs of trouble came in the bond markets then. As for today? That market can also give clues as to the likelihood of an economic downturn caused by other things, and to the potential severity of that downturn when it comes.
Right now, there are warning signs there that go beyond what most investors are aware of.
The obvious, most talked about sign, is the inversion of the yield curve. The continued decline in the yield on the 10-Year T-Note and longer-dated government debt has led to a situation where short-term rates are higher than their long-term counterparts. That suggests rate cuts in the future, something that generally comes in response to weakness in the economy.
That is a concern, but one thing should be clearly understood about the relationship between inversion of the yield curve and the possibility of a recession. An inverted yield curve has been a reliable indicator of an upcoming recession in the past, but with an important caveat: The downturn has typically come a year to a year and a half after the curve inverts.
It follows from that that what we are seeing now is only really worrying if it continues for a while, but keep in mind that this inversion began in March and is now at its greatest since 2007.
More worrying in many ways is what the bond markets are telling us about how severe any future downturn will be.
According to a report from Moody’s Investors Services released this morning, there has been a massive increase in borrowing by companies rated at the bottom end of investment grade. These are businesses whose creditworthiness is just one notch away from “junk,” and who are therefore very vulnerable should economic conditions deteriorate. If a slowdown lowered their rating, they would struggle to refinance their existing debt. Their problems would then make the overall situation worse, dragging others down, etc., etc.
In short, the current situation makes it likely that if there are problems ahead, they will be severe.
That big increase in bond issuance by the lower-rated corporations doesn’t exist in a vacuum either. It is part of a larger trend. Total outstanding corporate debt is around all-time highs as a percentage of GDP, and as this chart from this Forbes article shows, just like inversion, that has been a warning sign in the past.
Before you panic though, consider two things. The first is that, again just like inversion, the effects of an overall high debt load aren’t usually felt for a while. The above-referenced article, for example, was published back in August of last year and we still look to be far away from an actual recession, even now.
Secondly, there are very good reasons for the high debt. The “bubble” that is referred to on the chart above has been deliberately created by the Fed (and to a lesser extent by other central banks). They pushed interest rates lower in response to the last recession and have kept them there since.
The danger in high corporate debt comes when rates start to rise, and that happens when inflation appears. So far, despite all the stimulus by the Fed, inflation remains low and there is even talk of another rate cut, rather than hike.
It could well be that because of the nature of the recession and the Fed’s response, this time is different. At the very least, it is another indication that the problems that the bond market is anticipating could be some way off.
The point here, therefore, is not that investors should be selling their stock portfolios right now in expectation of a recession and a stock market collapse. It is simply to point out that the warning signs of a recession from bonds are increasing. That merits investors’ attention, whatever stocks do from here.