A Contrary Signal to the Baleful Inverted Yield Curve

The spread between BBB corporates and 10-year Treasuries is shrinking.

In “Stranger Things,” the hit Netflix supernatural series, the Upside Down is an evil place bent on destruction of our comfortable world. In economics, the equivalent is the inverted yield curve, long the harbinger of a recession.

Now, the curve has been inverted for about six weeks. The all-important bookends of this metric are the three-month Treasury bill (2.26% on Tuesday) and the 10-year Treasury note (2.07%), which is the benchmark for much of the US fixed-income scene.

But maybe there are some mitigating circumstances. A key reading from the bond market is not yet “flashing yellow,” wrote Joe Lavorgna, chief economist, Americas, at Nataxis, in a research note.

That would be the spread between 10-year Treasuries and BBB-rated corporate bonds of the same maturity. BBB bonds, which are one rung up from junk, are the hallmark of potentially iffy credits—and the difference is narrowing between their yields and those of 10-year Treasury bonds.

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When recessions are rolling in, that so-called “corporate spread” should be widening, thus signaling that bond investors expect a wave of BBB downgrades to junk, as well as defaults.

In the last quarter, Lavorgna pointed out, the spread diminished by 12 basis points (or bps, here 12 one-hundredths of a percentage point) to 182 bps. “This is only modestly higher than its trailing eight-quarter moving average,” Lavorgna stated, “and remains much in line with previous economic expansions.”

By contrast, he went on, 2000’s third quarter saw the yield curve invert and the corporate spread widened to 251 bps from 194 just two quarters earlier. A double whammy. The recession arrived in the first period of 2001.

This example also shows that an inverted curve must persist for a while, usually two quarters, before its ill portent becomes true.

And certainly, some argue that the yield curve’s predictive powers have waned, owing to distortions in the credit markets brought on by the Great Recession. To wit, the long season of low rates, the Federal Reserve’s campaign to purchase bonds (known as quantitative easing), and the allure of the 10-year Treasuries in a still-shaky world. Investors, many of them foreign, have snapped up the 10-year obligations, raising their prices and lowering their yields, thus  artificially pushing them below short-term Treasury yields.

Well, for now, optimists can content themselves with the corporate spread’s song of cheer.


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