Battle of the bonds

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Disagreements between equity bulls and bond bears are nothing new. But is the bond market arguing with itself? Take the government and corporate bond markets. Currently, 10-year Treasuries yield 4.4 per cent – 85 basis points below the Fed funds rate. For many, such a significant, enduring inversion of the yield curve is a sure sign of a sharp economic slowdown and rapid interest rate cuts.

That may yet come true, if the weakening US housing market has the impact doomsayers believe it will. But that does not tally with the exuberant corporate bond market, where credit spreads on both investment grade and high-yield bonds remain near all-time lows. If there really is a recession on the horizon, spreads should widen to reflect an expected rise in defaults.

There are explanations. The yield curve tends to be more predictive
of the future, while credit spreads can react more to actual events. Investment grade companies currently enjoy healthy margins and strong balance sheets in aggregate (although levels of gearing at some high-yield borrowers tell the opposite story).

In fact, the apparent divergence in views between Treasuries and corporate bonds might be less than it seems. There is an argument that Treasury yields have been forced down by excess money supply and the weight of global savings looking for a home – making the yield curve look overly pessimistic. That same liquidity factor could also be forcing down credit spreads as investors search for yield – making them appear overly optimistic about the economy. Booming demand for credit exposure through derivatives adds further downward pressure on spreads.

In spite of the Federal Reserve’s protestations about the solid US economy, it remains more likely that the next interest rate move is down and not up. But, when put in the context of the corporate bond market, the Treasury yield curve is not necessarily forecasting Armageddon.

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