Monday, July 30, 2018

Commercial bond yield inversions and recessions

 - by New Deal democrat

When my article on the yield curve was posted at Seeking Alpha last week, I got feedback that I ought to look at commercial bond yields as well, with some specific suggestions.

I did that, and I thought I would share the results.

One series that goes all the way back before the Civil War is the yield on commercial paper in New York. After 1971, it was discontinued, but AA-rated commercial paper rates took its place. Meanwhile AAA-rated corporate bonds (lower-yielding and less volatile than other grades) have been tracked since 1919.  That means that we can put together the relationship between short term and longer term corporate bond yields going back just one year short of a century.

In the below two graphs, AAA corporate bonds are shown in blue, the three sequential commercial paper rates shown in shades of red. I have overlapped those series as much as possible to show that the changeover makes no material difference.

Here is 1919 through 1971:

and 1971 to the present (sorry, I accidentally cut this off in 2015. Since the 3 month AA paper has risen gradually to 2% yields):

This gives us a result very similar to that of the Fed Discount and Funds rates vs. long term Treasuries.  An inversion is always bad (except for 1966), but inversions don't always occur. Most importantly, note that commercial bond yield spread never did quite invert before the Great Recession.

Because it does seem that the difference in the two yields generally tightens before recessions occur, I also looked at the two time periods that way, by subtracting short term commercial rates from long term commercial rates:

It's noteworthy that even in those cases, a tightening by 1/2 of the highest term spread between long and short term yields always signals a recession within 2 years, with the very notable exceptions of the mid-1960s and the late 1990s. But again, there was no appreciable tightening before the 1938, 1945, and 1950 recessions. 

Note, by the way, that this year corporate term spreads have decreased by more than 1/2 from their expansion high, indicating heightened risk (but not a certainty) of a recession within 2 years.

The bottom line I hope you take away from all of my writing about the yield curve is that, while it is a very useful metric, it is not foolproof, and ought to be used in conjunction with other reliable metrics emanating from other sectors of the economy.