24 January 2012 at 13:09 GMT
Credit spreads say recession risk is high, but is the bond market wrong?
The spreads between BAA corporate bonds (the lowest investment grade rating) and US 10-year treasuries are normally a good indicator of economic recessions (see chart below).
Normally the spread peaks around the 300-400 basis point interval in a recession (with the recession in 1991 being the exception). With the spread currently at 337 basis points the bond market is indicating that the risk of recession is very high. Please note that due to the few recessions (seven since 1961) the conclusions may have a high standard error.
More interestingly, the chart below says that the perception of recession risk in the bond market has not eased. In fact the year-over-year changes in the spread is still in positive territory.
So is the bond market right or is it overestimating the probability of a recession?
Well, forecasting recessions is done by almost every investment banks' economic research department but many do not get it right. We are regular readers of Jeff Miller's blog "A Dash of Insight" which has good objective comments on the economy. Recently Jeff has begun a series of articles describing which recession forecasting seems to be the best. He has several criteria for such models and
this article describes one of the recession forecast models he has chosen. The other model is the
Super Index. It is not the aim of this equity update to provide detailed analysis about the models and we encourage you to read the articles we have linked to if you want to improve your knowledge on recession forecasting.
Nevertheless, both models predict a very low probability of the US economy going into a recession within the next four to nine months (see screenshot below). The conclusion is that two of the most reliable recession forecasting models disagree with the bond market and presumably the market in general as investors on average are currently pessimistic about the future.
Source:
A Dash of Insight
If you have confidence in the future and believe the economy is not falling into a recession again stocks could be a good play relative to bonds over the next 12-48 months as the global economy is likely to continue expanding.