Calling the next recession has become a favourite parlour game for the talking-heads and pundits who opine on market matters. It’s understandable why, given the ongoing trade war, global slowdown, and persistent geopolitical uncertainties – and of course, let’s not forget the recent inversion of the yield curve.
Indeed, economists, strategists, data scientists, and even psychologists have analysed that inversion to no end. Their consensus? An inverted yield curve often signals recession – but not always. And when it does, the recession might not hit for a while. How’s that for clarity?
Fortunately, another historically reliable (and less noticed) indicator is signalling that a recession scenario remains somewhere well over the horizon barring some major shock.
This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
Calling the next recession has become a favourite parlour game for the talking-heads and pundits who opine on market matters. It’s understandable why, given the ongoing trade war, global slowdown, and persistent geopolitical uncertainties – and of course, let’s not forget the recent inversion of the yield curve.
Indeed, economists, strategists, data scientists, and even psychologists have analysed that inversion to no end. Their consensus? An inverted yield curve often signals recession – but not always. And when it does, the recession might not hit for a while. How’s that for clarity?
Fortunately, another historically reliable (and less noticed) indicator is signalling that a recession scenario remains somewhere well over the horizon barring some major shock.
Corporate Bond Spreads Lead Recessions
Corporate bond spreads start trending wider well before recessions. Looking at the runup to the past two recessions, it is clear that investment grade and high yield spreads started widening well before equities cracked (Chart 1). The IG spread widening is more obscure on this scale, but it is there, and highly correlated with HY.
Chart 1: Credit Spread Vs. S&P 500
Source: FRED
Sharp readers may also note that there were spread widening episodes that did not lead to recession. In 1998, spreads gapped out during the Long Term Capital debacle, but this was closely aligned with a selloff in equities and a spike in equity volatility. There were similar widenings in 2011 (the US debt ceiling crisis) and December 2018 (confluence of slower growth, China trade tensions). Both were in line with movements in equities and volatility.
The outlier is the 2015-16 period, when credit spreads gapped out by 375 basis points while the S&P 500 mostly traded in a narrow range. But there was no recession.
A closer look gives a more nuanced perspective. During this period oil prices fell to $30/bbl and commodities prices collapsed, setting off a chain reaction of distressed defaults in the high yield energy and mining/metals sectors. Many of these companies were unlisted or small caps. The large cap S&P 500 fell 11.7% between June 2015 and February 2016, but the Russell 2000 equity index of smaller cap companies fell 24.7% over the same period.
More to the point, the HY index started widening in early 2015, two quarters before equities hit the high for 2015. The broader economy avoided recession, but the corporate market signalled that certain sectors of the economy and corporate market would effectively go into recession.
Credit Spreads Give Better Read On Recession Risk than Yield Curve Slope
How did the credit spread recession indicator fare against the slope of the yield curve? Before the 2001 recession, HY spreads started widening at roughly the same time as the 10Y-2Y slope turned negative and well before the 10Y-3M slope inverted. The two sectors were roughly in synch.
Before the 2008-09 recession, however, the yield curve flattened and inverted more than a year before HY spreads moved decisively wider. Both anticipated recession – but the credit market gave a better reading of its approach.
Chart 2: HY Spread Vs. Yield Curve Slope
Source: FRED
CCC Sector is a Yellow Flag
Let’s take a closer look at HY spreads by rating cohort (chart 3). The low rated CCC sector is highly volatile, but note that the BB and B sectors are usually (though not always) highly correlated.
One point that stands out is that, unlike the BB and B sectors, the CCC sector never really recovered after the December 2018 selloff. That’s a similar pattern to 1998, when CCC spreads didn’t recover after the LTCM selloff. Certainly in retrospect that was a yellow flag, but recession risk didn’t start rising until BB and B spreads widened (and the yield curve inverted).
Chart 3: HY Sector Spreads
Source: FRED
The Bottom Line
In our view, credit markets are not signalling a recession nor meaningful rise in default rates in the coming two to four quarters. Yes, there is the yellow flag or two, and ongoing geopolitical tension will probably lead to more volatility and selloffs. But it is still too early for all but the most cautious of investors to move out of risk assets. Meaningful selloffs are still buying opportunities.
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.