Junk Spreads Show US Economy Is Close To A Recession

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by Tyler Durden
Thursday, Mar 30, 2023 - 11:20 AM

Authored by Ven Ram, Bloomberg cross-asset strategist,

The US economy may be on the brink of a recession if an early sign of distress in the credit markets is anything to go by.

The spread between high-yield dollar-denominated corporate bonds and those on investment-grade securities widened to touch 367 basis points this month.

That level has been a sufficient trigger to herald a contraction of the world’s largest economy in data going back to the start of the millennium.

The average differential that coincided with the onset of a recession was 354 basis points in December 2007 and 276 basis points in February 2020.

Federal Reserve Bank of Minneapolis President Neel Kashkari said over the weekend that the recent bank turmoil has raised the risk of a US recession, remarking that the tumult “definitely brings us closer” to one.

Fed Chair Jerome Powell said after last week’s policy review that a significant number on the open market committee “expect credit tightening” following the failure of Silicon Valley Bank and Signature Bank. It didn’t help investor sentiment that Credit Suisse, a systemically important entity, was on the brink before its takeover by UBS.

Even so, while the Fed lowered its economic-growth estimate for 2023, it has only dropped it a notch to 0.4% from 0.5%. Rather than underscoring optimism, the latest projection may reflect the fact that it’s too early for the FOMC to assess the fallout of systemic stress.

While the Bloomberg Financial Conditions Index has gone from signaling a loose policy backdrop at the end of last month to one that is sharply tight now, it is nowhere near what it was telegraphing during, say, the onset of the pandemic-led recession. However, Powell acknowledged that financial conditions may have tightened more than traditional indexes show because they don’t capture lending metrics.

Meanwhile, the differential between 10- and two-year Treasury yields has gone to -50 basis points from -110 basis points.

That steepening after a long period of flattening usually signals an economy on the cusp of a contraction.

Still, it’s useful to keep in mind that dating recessions is far from a linear function and hence tricky to call in real time. If we are on the threshold of a contraction, we won’t know for sure right away. The National Bureau of Economic Research, tasked with determining the date, usually declares the onset with a considerable lag.

Regardless, there is little doubt that the banking failures in the US and the ripple effect of Credit Suisse’s takeover have tightened financial conditions considerably.

That’s had an adverse impact on consumer sentiment, which may be enough to hobble the US economy.

To what degree is the key question.