September 16, 2011
Industrial Production Vs. Credit Spreads
Yesterday’s update on industrial production looks surprisingly good at a time when the only news from the economic front seems to be bad news.
True, industrial production’s rise of 0.2% last month was relatively modest, but the 3.4% annual percentage increase for this series suggests that the economy will chug along. History implies that if there’s a recession approaching we’ll see the annual change in industrial production drop rapidly, and soon. For now, however, it’s holding up quite nicely. But how much confidence do we have that it'll remain so?
Looking forward is tricky, of course, but researchers offer a number of guides for developing some reasonable guesses. For instance, credit spreads have a decent record of dropping some clues about the future path of industrial production. As a 2001 study from the IMF reports:
Corporate spreads reflect default risk, which conveys information about the business cycle. Our empirical results support this assertion and indicate that corporate spreads to treasuries predict changes in real activity up to a twelve-month horizon, as increases in corporate spreads precede industrial production slowdowns.
Unfortunately, corporate spreads are rising again. There’s still room for debate about whether they're at the point of no return, but the recent jump in credit yields over Treasuries isn’t encouraging in the current climate.
Consider the difference in yields between Moody’s Baa Corporate Bond and 20-year Treasuries (the 20-year maturity is used because that approximates the average maturity for the Moody’s benchmark). As of September 14, Moody’s Baa Corporate yield exceeded the 20-year Treasury by roughly 240 basis points—the highest since July 2009 (see second chart below). Based on the forward-looking properties of credit spreads, and what we know about current economic conditions, that’s not a good sign.
Another study (“Credit Spreads and Business Cycle Fluctuations”) from last year explains why:
An increase in the excess bond premium reflects a reduction in the risk appetite of the financial sector and, as a result, a contraction in the supply of credit with significant adverse consequences for the macroeconomy.
Other analysts have uncovered similar results. A Dallas Fed study, for instance, notes:
We find that shocks to lending spreads in the market for long-term corporate debt cause immediate and prolonged contractions in output. Credit market shocks were found to have had a negative impact in the 2001 and 2007-9 recessions.
But the Treasury yield curve is still positive, the 12-month change in the stock market remains in the black, and there are several other sources for optimism. Perhaps it's premature to run the white flag up the pole just yet. But let’s not kid ourselves about recent activity. Job growth has weakened and it may be destined to fade further, as yesterday’s discouraging news on jobless claims suggests.
"It feels like a recessionary environment,” says Bart van Ark, chief economist of the Conference Board via The Wall Street Journal. He estimates the odds of a new downturn at 45%. The Journal notes that “since 1988, every time the Conference Board's estimate of the probability of recession topped 40%, a downturn followed shortly thereafter.”
But the future’s still unclear, as always, and that may be a good thing at this point. A few more dispatches of major slices of macro updates will bring quite a bit more clarity on what’s coming. Meantime, no one needs much of an excuse to stay wary. All the more so if the credit spread keeps rising.
Posted by jp at September 16, 2011 11:38 AM
One more thought on the cancelation of this relationship - Fed's operation twist can be driving up the spread without the risk appetite being the driver.
Posted by: carl at September 18, 2011 5:31 PM
The spread is rising whilst baa falls. I wonder if a falling baa cancels out this predictive capability of the spread.
Posted by: Carl at September 18, 2011 5:29 PM