3 Lessons From the Bond Market

Does the sell-off in stocks and bonds signal a recession? Maybe, but as economist Paul Samuelson observed, market indexes have predicted nine of the past five recessions. The truth is that even those with a strong record are bound to have exceptions and surprises. When worries over housing markets were building prior to the 2008 financial crisis, they were dismissed as uninformed because local housing markets around the country had always moved independently of each other. It's worth keeping that in mind as others argue that a nascent yield-curve inversion will prove a better recession signal than Samuelson's market indexes. A few other reminders:

1) Until recently, it was obvious that Treasury yields were on the verge of rising out of control. Panic over the fallout from massive monetary and fiscal stimulus to rescue the economy and banking system took hold almost immediately at the end of 2008 as pundits predicted that we were heading for a catastrophe. The bond market has arguably been a lot calmer than the pundits, but that panic led to fear of soaring Treasury yields. By April 2010, the yield curve implied that they would hit around 5.5% five years hence. Needless to say, they didn't. Nor did the market's expectation five years ago come true that 10-year yields would be higher than 4.5% by today. (They finished Dec. 7, 2018, at 2.85%.)

2) Things can reverse course quickly. That's what happened when the crisis surged in 2008. Five-year forward expectations for the 10-year went beyond 6% in the middle of 2007. That figured drifted down to the mid-5s by mid-2008 and then fell off a cliff. By mid-December 2008, it had been slashed by more than half. The cycles have been longer in the absence of depression panic, and it's way too soon to judge where things are headed now. After more than two years of building forward-yield expectations and the recent sharp shift in sentiment--bringing worries of recession much closer--the curve has begun ratcheting them down, predicting that 10-year Treasury note yields will still be around 3% five years from now.

3) Trouble may lurk where you least expect it. It's conventional wisdom that nobody but the heroes of The Big Short anticipated the housing crisis. That's not really accurate, but even many of the sharpest observers didn't anticipate the suffering that afflicted munis. Many did worry about the health of bond insurers that guaranteed the market's highest-rated paper. What few realized, though, was that hedge funds, in particular, had gorged on tender-option bonds--leveraged investments typically created with high-quality municipals. Massive selling kicked in when dealers and hedge funds had to collapse those tender-option bonds, and the outsize pain in the highest-quality muni debt shocked many.

What, Me Worry? It's unlikely many will have anticipated the next similar surprise, but there are candidates. Risk in the booming leveraged bank-loan market is triggering a lot of worry, but much of their issuance has been soaked up by collateralized loan obligations, which offer high-quality tranches that could feel heat if their underlying loans falter. Similarly, many have focused on growing risks in the BBB sleeve of the corporate-bond market, which has lost more than 3% thus far in 2018, while the U.S. high-yield market has been flat. The latter is less than one fifth the size of the high-grade corporate market, though. Any downgrades of meaningful size out of the investment-grade strata could flood the high-yield market with supply and drive down prices there, even if its natural inhabitants managed to avoid their own trouble.

There's another corollary that's probably even more well known then Samuelson's, which is that markets hate uncertainty, and that's no doubt part of human nature itself. If there's a comfort to be derived from these stories, though, it's that investors who have embraced that uncertainty, holding sensible portfolios over the years without jumping in and out of the market would have done just fine despite those zigs and zags.