Monday night I heard of a recession indicator that I had never heard of before and it just triggered the first recession alarm. The indicator is the spread between the Bank of America Merrill Lynch U.S. High Yield Index Option Adjusted Spread and the Fed Funds rate.
Let me state that I learned of this indicator late Monday night/early Tuesday morning. I am a junkie about the market and basketball and switched from an NBA summer league game over to Bloomberg somewhere around Midnight to check on overseas markets and to see what domestic futures were doing. I tried to find the interview the next day, but I couldn’t find the interview or the chart that accompanied it. I didn’t even get the guys name, so it made it difficult to find.
Nevertheless, I started looking at the spread between high yield bonds and the Fed Funds rate. When the Fed made the rate hike in June, it brought the target rate up to 1.75%. The high yield rate spread has been declining since early 2016 while the Fed has been raising rates. The option adjusted spread has been vacillating between 3.25% and 3.75% for the last six months and registered a reading of 3.59% on July 10.
The recession indicator is triggered when the spread between high yield bonds and the Fed Funds rate drops below 2%. With the Fed Funds rate at 1.75% and the BAML rate at 3.59%, we have that scenario now and that has been the case for the past month. The last time this happened was in 2007 and the time before that was in 2000.
I know I have talked about the inverted yield curve before and that is a far more watched recession indicator. When the 2-year treasury has a higher yield than the 10-year, that has been a very reliable recession predictor over the years. Both of these indicators make sense to me. When the spread between junk bonds and treasuries is less than 2% it is a sign that junk bonds are extremely overbought and are ready for a major drop. The reward doesn’t justify the risk at that point.
When the 2-year is yielding more than the 10-year, it is a sign that investors are less optimistic about the long-term outlook for the economy. It also causes problems for companies that borrow on a short-term basis as their borrowing costs increase.
Am I panicking about the spread between high yield bonds and treasuries? No, but I will certainly be keeping an eye on other indicators such as the 2-10 spread, the leading indicators report, etc. I have never been one to look at one indicator or one analysis style and take action based on one thing.
The trend for the market was upward in 2017 and has been more sideways so far in 2018, but all four of the main indices are still above their 52-week moving averages. The labor market is still growing and GDP is still positive. I have concerns about certain aspects of the economy and I am worried about the impact the current trade disputes could have going forward if we don’t come to an agreement on all fronts- Canada, China, Mexico and the EU. But I am not suggesting that you panic about stocks. If you are invested in junk bonds, yeah, you might want to lighten up on those holdings.