What Are Bond Markets Saying About the Economy?

Dave Sekera: At times of major market reversals, there is an old adage that bonds lead and equities confirm.

What this saying implies is that, oftentimes, movements in the bond markets presage changes in the economic environment and the equity markets. However, the bond market is not infallible, and investors often joke about how the bond market has called seven of the past four recessions. This means that the bond market also has a history of indicating major turning points when no turn actually occurs.

In June 2014, corporate credit spreads reached their tightest level since prior to the credit crisis. Since then, oil and commodity prices have steadily declined, and credit spreads in the energy and basic-materials sectors widened out to account for the rising credit risk. As these sectors widened, it pulled the overall corporate bond market wider as well.

Initially, the weakness was generally contained to these two sectors; however, more recently, this weakness has accelerated and spread. For example, since reaching its tightest spread level, the Morningstar Corporate Bond Index has widened 110 basis points, with half of that widening occurring in just the past three months alone. The equity market corrected last fall, rebounded, and has now corrected again, having fallen about 11% off of its highs.

The current conundrum is to determine if this movement is indicative of a major turning point that still has further to run, or just a correction from overvalued levels as a reaction to the decline in energy and commodity prices. On the economic front in the U.S., many recent metrics, such as the January payrolls report, indicate a deceleration in economic growth. However, once adjusted for weather and seasonal factors, Robert Johnson, our director of economic analysis, believes economic growth is in better shape than generally believed. In fact, upon making those adjustments and taking into consideration strong wage growth, Johnson stated that he has a very hard time envisioning a near-term recession. From a credit-market perspective, there will be an increase in default rates as energy companies whose costs are too high go under. However, those risks are substantially priced in as the price of bonds in the energy sector has fallen considerably.

When contemplating a significant further downturn from here, it is most likely exogenous factors internationally that could cause this recent correction to extend into a major downturn. Indicators to watch that could indicate a weaker environment include a greater deterioration in commodity prices, a hard economic landing in China, or significant credit-spread widening of European banks.

If commodity prices fall further, then the price of bonds in the energy and basic-materials sectors will fall as the recovery value of those companies that file bankruptcy will decline. Lower commodity prices may also indicate a weaker demand due to a general global economic slowdown, as opposed to just an oversupply issue.

As the second-largest economy in the world, if China experiences a hard economic landing, then the ripple effect would reverberate across those economies tied to the Chinese economy. In addition, the Chinese banking system would incur significant losses and could lead to a significant devaluation of the renminbi, leading to global economic disruption.

Finally, the last indicator to watch is the credit-spread levels for major European banks. Recently, Deutsche Bank and Credit Suisse have reported large losses. If this weakness extends to the banks in the peripheral eurozone countries such as Italy and Spain, and the solvency of those banks is called into question, then we could see a reprise of the European banking and sovereign-debt crisis that we saw in 2011.