[Chart Of Interest] The Credit Market Is Calm...Too Calm...

The [Chart of Interest] post is a weekly blog spotlighting a highly informative chart and the significance on asset markets through the lens of the EPB Secular & Cyclical Framework.

[Chart Of Interest] The Credit Market Is Calm...Too Calm...

The US investment-grade credit market has been remarkably calm in the face of significant and widespread declines in the equity market.

The effective yield of US corporate bonds has increased substantially, putting pressure on corporate earnings, but most of the increase is coming from the benchmark Treasury rate.

BBB-rated spreads are only ~180bps above Treasury bonds, very low relative to the 20% drawdown in major equity indexes.

Credit spreads materially widened four times since the 2008 recession before today's increase.

In 2011, there was a European debt crisis and a significant slowdown in US economic growth. The US economy did not fall into a recession, but the new orders index from the ISM report fell to 51.3, a level that is close to recessionary conditions. The S&P 500 declined by roughly 15%. BBB-rated credit spreads rose over 300bps.

In late 2015/early 2016, there was another major US economic slowdown, a 10% drawdown in the S&P 500, and a recessionary ISM new orders reading of 48.8. The economy recovered before a full recession thanks to major stimulus in China, but BBB-rated credit spreads still rose to 300bps.

In 2018, another major slowdown and 20% S&P drawdown hit the US and global economy while the Federal Reserve was raising interest rates. The ISM new orders index tumbled again to 51.3, but the Fed made a hard pivot and started to ease monetary policy before BBB-rated spreads rose much more than 200bps. Similar to today's situation, in 2018, corporate rates rose mainly from the benchmark Treasury.

Today, the S&P 500 is down roughly 20%, and the Fed is likely to continue engaging in massive monetary tightening. While the ISM new orders index has only declined to a low of 53.5 so far, the odds of a US recession in the next 12 months are higher today than the three previous non-recessionary slowdowns based on leading indicators discussed in the last Monthly Cyclical Trends Update.

BBB spreads are unusually calm given the 20% decline already experienced in equity markets. The credit market is resting on the fact that employment remains strong, and the ISM new orders index, a proxy for growth, has only declined to a local low of 53.5. If the ISM new orders index moves towards 50 over the next several months, even a non-recessionary event could put spreads in the 300bps range, which would add another 150bps to effective corporate yields.

In July of 2021, the effective yield on BBB-rated paper was ~2.25%. If spreads widen upon the realization of recession risk and Treasury rates hold at the elevated level of 3.25%, we could be looking at 6%-7% corporate rates in the near future.

A 20% drawdown in the S&P 500 may not be fully discounting the impact on corporate profitability from 7% borrowing costs.

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