Fra Moodys:
Very Wide Spreads Warn of Danger Ahead
Ultra-wide high-yield bond spreads have offered useful insight regarding where the US economy is in the business cycle. The high-yield bond spread’s month-long average has been at least 800 bp for only 32, or 8.6%, of the 373 months since year-end 1984.
Of special importance is how a recession was either fast approaching or already present whenever the highyield spread’s month-long average first broke above 800 bp more than two years after a business cycle bottom. Thus, the high-yield bond spread’s 848 bp average of February-to-date merits widespread attention.
The high-yield spread’s month-long average previously first broached 800 bp at least two years after a cycle trough in August 2008, November 2000, and October 1990. Only November 2000 is similar to February 2016 in that both months overlapped business cycle upturns.
Nevertheless, one major difference between November 2000 and February 2016 centers on how much higher November 2000’s average expected default (EDF) frequency metric of 11.9% for US/Canadian noninvestment-grade companies was relative to February-2016-to-date’s average of 8.1%.
Mostly because of an exceptionally steep high-yield EDF metric, the high-yield spread’s multi-variable regression model predicted a high-yield spread of 869 bp for November 2000 that was wider than November 2000’s actual gap of 835 bp. By contrast, the same model currently predicts a 722 bp spread for February 2016, which is substantially less than February-to-date’s average of 848 bp.
The actual high-yield spread last exceeded the predicted spread by a comparable margin in the summer of
- The high-yield spread would subsequently narrow from its 634 bp average of the summer of 2012 to 481 bp by Q1-2013.
If the macro backdrop does not deteriorate and if the VIX index does not climb higher, the high-yield spread could narrow even if the high-yield EDF metric remains in a range of 8% to 8.5%. However, the latter may be asking for too much given the sluggishness of core business sales, especially relative to the now faster growth of labor costs.
High-yield spread’s rising trend flashes danger
In addition to the warning implicit to a wider-than-800 bp spread, the now rising trend of the high-yield spread’s moving 12-month average suggests that complacency is ill advised. Recessions were either present or less than a year away each time the high-yield bond spread’s moving 12-month average topped 600 bp two years after the cycle bottomed. Thus, the nearness of a possible downturn deserves consideration in view of how the high-yield spread’s latest yearlong average was 573 bp and rising. (Figure 1.)
Figure 1: As Derived from Consensus Outlook for Baa Yield Spread, High-Yield Bond Spread May
Reach Reach a Recession-Prone Range Later in 2016
Consensus implicitly foresees a wider-than-700 bp high-yield spread into 2017
The best readily available consensus forecast of the high-yield spread portends an increased likelihood of a recession. Though consensus projections for the high-yield bond spread are lacking, such projections can be inferred from the consensus outlooks for the yields of Baa-rated corporate bonds and benchmark Treasury securities. These consensus forecasts now strongly favor the arrival of a yearlong average for the high-yield spread that will ultimately top 600 bp by a very wide margin.
Both the Philadelphia Federal Reserve Bank’s Survey of Professional Forecasters and Blue Chip Financial Indicators supply consensus views on Moody’s long-term Baa corporate bond yield. Since September 1988, the long-term Baa corporate bond yield spread reveals a very strong correlation of 0.93 with the high-yield bond spread. In turn, a reasonable forecast for the high-yield spread can be inferred from consensus outlooks for the Baa corporate bond yield and the relevant benchmark Treasury yield. (Figure 2.)
Figure 2: Long-term Baa Corporate Bond Yield Spread Shows a Strong Correlation of 0.93 with the High-Yield Bond Bond Spread
As derived from the unweighted average of the latest available consensus projections, Moody’s long-term Baa corporate bond yield spread is expected to average 250 bp over the next 12 months. A 250 bp spread for the Baa corporate yield supplies an expected midpoint forecast of 781 bp for the high-yield bond spread during the next 12 months according to an ordinary least squares regression model.
Spread outlook warns of a much higher default rate
Such a wide spread over a yearlong span warns of well above-trend default rate, as well as elevated recession risk. As derived from the statistical relationship between the US high-yield default rate and the high-yield bond spread’s yearlong average, a reading of 781 bp for the latter tends to be associated with a default rate of 7.7%. Thus, if the high-yield spread averages 781 bp over the next year, the high-yield default rate should rise considerably above January 2016’s 3.1%.
However, to the degree the attainment of a 7.7% default rate by Q1-2017 is viewed as being unlikely, February-to-date’s average high-yield spread of 848 bp implies that the accompanying composite speculativegrade bond yield of 9.76% now grossly overcompensates for default risk. Still, the default rate’s now rising trend and the likelihood of a recession by 2018 may limit the scope of any rally by high-yield debt. It’s much easier to make a case for high-yield bonds because of fundamentally excessive spreads when the default rate is widely expected to decline. Such is hardly the case today.
Base metals prices steady while the price of oil struggles
Of late, industrial metals prices have fared much better than the price of crude oil. Though February 17’s base metals price index was down by -18.4% from a year earlier, it edged higher by 0.6% since year-end 2015. By contrast, as of February 17, the price of WTI crude oil was down by -17.2% since year-end 2015 and off by 41.2% from a year earlier. (Figure 3.)
Granted that a number of loans to lower grade oil & gas companies are likely to sour, the record still shows that world economic growth has a much stronger correlation with the annual percent change of the base metals price index compared to the annual percent price change of WTI crude oil.
The yearlong average of Moody’s industrial metals price index has declined by at least -9% annually in nine of the 37 years since 1978. For each of the nine episodes, the IMF’s estimate of real GDP growth slowed from the previous year. Thus far in 2016, the base metals price index has contracted by -23% year-over-year.
Because the year-over-year comparisons become easier as 2016 progresses, it’s premature to conclude that 2016’s yearlong average for the base metals price index will slump by more than -9% annually. Thus, it’s too early to dismiss the possibility of somewhat faster growth for the world economy in 2016, especially since the base metals price index has climbed higher by 9% from its 2016 low of January 12.
Nevertheless, a now expected slowing by US real GDP growth from 2015’s 2.4% to 2.1% in 2016 (according to the Blue Chip consensus) suggests that world economic growth may not improve on its prospective 3.0% rise for 2015.
Figure 3: Since Year-end 2015, Price of Crude Oil Was Recently Down by -17.2%, while the
Industr Industrial Metals Price Index Inched Up by +0.6%
Crude Oil Price: WTI, $/bbl ( L ) Industrial Metals Price Index: ( R )
