Money

Bond-market reality: Crushing investors’ hopes for soft landing

  • The “junk spread” is at a historically low level, raising the risk of a recession
  • Contrarians believe the low spread reflects an excess of exuberance that will correct itself
  • The junk spread has greater explanatory power in the one- to three-year horizon

Introduction

The current state of the bond market is sending a warning signal to investors. The “junk spread,” which measures the difference between the yield on corporate high-yield bonds and U.S. Treasurys, is abnormally low right now. This means that investors believe economic risk is minimal, leading to concerns of a potential recession. Contrarians argue that this low spread is a sign of excessive optimism that will eventually correct itself. This article explores the implications of the low junk spread and the potential risks it poses to the economy.

Economic Insights

Historical Analysis

Historical data shows that the current junk spread of 3.5 percentage points is well below its average since 1997, which stands at 5.4 percentage points. This indicates that investors are underestimating the economic risks at play. Contrarians believe that when everyone thinks alike, they are likely to be wrong, and the low spread represents an excess of exuberance that will eventually correct itself.

Contrarian Indicator

The junk spread serves as a valuable contrarian indicator for assessing investor sentiment. Unlike most other sentiment indicators that have a short-term horizon, the junk spread has greater explanatory power in the one- to three-year range. This means that the risk of a recession may not be immediate, but it is likely to persist in the coming years. This analysis suggests that the heightened risk of a recession is not going away soon, even if it doesn’t guarantee that a recession will occur.

Conclusion

The abnormally low junk spread in the bond market is a cause for concern. It indicates that investors are underestimating the economic risks and may be overly optimistic about the current state of the economy. Contrarians argue that this excess of exuberance will eventually correct itself, leading to a potential recession. While the junk spread has a longer explanatory horizon, it suggests that the risk of a recession is not going away soon. Investors should be cautious and consider the potential implications of this bond-market reality.

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