Bond Market Rally: It’s Not Time for Economic Celebration Just Yet
Be careful how much you read into the recent bond market rally. It may not spell great economic times to come, as some are suggesting.
Remember, the debt market was a source of concern just a month ago. Spreads on corporate bonds, the difference in interest rates that companies have to pay to borrow money and the rate on U.S. Treasuries, were rising and had reached their highest level in a while. It signaled that bond market investors thought companies would have a harder time paying back their debt. And several commentators were saying that was a bad thing for the economy because companies would have to pay more to borrow, lowering earnings. That added to the anxiety over the stock market coming into October.
October, though, was a good month for corporate bonds and bond sales. Companies with investment grade credit issued more than $100 billion in bonds. And corporate bond markets rallied, lowering borrowing costs. And the spread between corporate bonds and Treasuries narrowed. So nothing to worry about, right?
Not quite. Over the past few years, there has been a lot of discussion about the connection between the stock market and the economy. The Dow Jones Industrial Average shot up well before the unemployment rate fell. And stocks have been falling lately while the unemployment rate is the lowest it has been in years. This has led some to conclude that the stock market is not a great indicator of where the economy is headed. It’s just traders, high frequency computers really, pushing the price of stocks up and down.
At the same time, though, there seems to be a consensus on Wall Street that, unlike the stock market, the bond market has the ability to predict the direction of the economy. Jim Bianco, an investment strategist who runs his own firm in Chicago, says that has been the case in the past. But there are a number of reasons to think that’s may not be the case this time. First of all, bond yields are at historic lows. That’s made any move in the bond market look bigger, and more predictive, than it is. Second, as Bianco points out, energy companies have done a lot of the new borrowing over the past few years. And given the recent drop in the price of oil, energy companies may struggle to pay back their debts. That’s tied the health of the bond market to the price of oil much more than usual. But while low oil prices could be bad for indebted energy companies, it actually should be good for the economy in general.
Tom Atteberry, who manages the FPA New Income fund, says the other problem with the bond market is that the majority of borrowing seems to be for corporate stock buybacks or M&A, not to fund corporate expansion projects. So, just because companies are borrowing more doesn’t mean we will see more economic activity.
Even if the bond market tends to lead the stock market, that doesn’t seem to be the case now. Bond markets sold off in August and September due to an extreme and unpredicted rise in volatility in the stock market and fears that an emerging market slowdown was going to hurt the U.S. economy. Those fears have eased. The stock market rallied in October. In general, that’s made investors less risk-averse, and the bond market has rallied. “There are times when the bond market leads the stock market and times when the stock market leads the bond market,” says Jim Keenan, global head of fundamental credit at Blackrock. “I don’t think the bond market’s predictive power is that much better than the stock market.”
Lastly, the bond market hasn’t been all that helpful as an economic indicator. Corporate bond spreads hit their narrowest levels in June 2014, when the average corporate borrowing rate was 1.06 percentage points higher than average Treasury yields. From there, corporate bond spreads started to grow wider, meaning the bond market was getting nervous. But that was more than a year ago, and by most accounts the economy has continued to improve, albeit slowly. Last month, corporate bond rates were 1.8 percentage points higher than Treasuries. And now they have shrunk to 1.67 percentage points. But that’s not a very big move.
The bond market might be telling you something about where the economy is headed. But these days I’m not sure I would trust it any more than the Dow.