Recession Bunk

The latest ISM manufacturing index reading of 49.1 has added to recession talk.  Recall, however, that the index must fall below 48 to signal a recession, and that it has often moved below 50 for a month or two and then rebounded.  That pattern probably reflects an inventory correction which, when completed, requires an acceleration in orders and production.

Other leading indicators such as initial unemployment claims, stock prices, housing starts and consumer confidence are not signaling recession.  Indeed, the drop in mortgage rates has produced a refi boom and is boosting housing activity.

But what of the inverted yield curve?  Isn’t that a recession signal?  Not when the cause of the inversion is a drop in rates!!!  Past prerecession inversions occurred when short-term rates were rising faster than bond yields.  That combination sent mortgage rates higher and pushed housing into recession.  In this instance, bond yields have declined and pulled down mortgage rates.  Someone needs to explain to me how lower rates would cause a recession.

If investors are forced to revise recession expectations, they would also need to revise rate expectations.  In that event, the very crowded long-bonds trades would get reversed and the consequent price action could be brutal.  The Wall Street Journal today described the duration extension trades mandated by the jump in refi activity and the lengthening duration of pension liabilities (remember learning about negative convexity?).  That helps explain the latest phase of the Treasury market rally, but it also identifies another source of selling if rates start to move higher.

The high yield market did not participate in this latest rally, so it is offering reasonable spreads to Treasuries.  That cannot be said about investment grade corporates or munis.  They are as expensive as Treasuries.  For example, the August rally produced total returns of 3.5% for Treasuries, 3.0% for IG corporates, 1.6% for municipals and only 0.4% for high yield corporates.  The high-yield to Treasury market spread is now around 430 bps, which is on the high side for a period of low default rates.  To be sure, if markets expected a recession, they would also expect an increase in default rates and wider high yield spreads.  If, however, those expectations are overdone, the current spreads are better than fair.

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