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Is The Bond Market Beginning to Offer Recession Concerns?

CAMS Weekly View from the Corner – Week ending 5/13/2022

May 16, 2022

Under the broad umbrella of the bond market there are numerous bond categories that can be operated within. Being the bond market has proven time and again to be quite intelligent and reliable with its forward messaging for other markets, as well as the general economy, we took note this past week of a subtle message. To be fair, at this juncture, highlighting this activity can easily be considered premature and we agree. At the same time, two previous messages sent by this market in the past decade-plus unfolded rapidly once it began to show a change in behavior. Also to be fair, there were a couple of occurrences in the same timeframe that began to show problems that faded away and turned out to be a non-issue. Namely we saw the behavior of the 10 Year Treasury bond along with Corporate High Yield (“Junk”) bonds act a bit differently than what has been customary thus far in 2022 even with the extreme challenge the bond market at large has been experiencing. To this point in the year the story for the difficulty in the bond market has been the price inflation backdrop and through this the Federal Reserve’s necessary policy action of raising their Fed Funds Rate to help combat it. We can sum this up by labeling the issues to this point as an inflation/interest rate issue. The question is will this and the follow-on issues from it spill over into the economy that reduces it to recession? One way the bond market chimes in on this question is by selling Corporate High Yield bonds far more than that of Treasury bonds. That is, as bond participants become more concerned that inflation/interest rate risk will impact the forward health of the general economy they sell the High Yield bonds in droves being they already represent higher risk on the credit quality front. This is why they are known in slang as “junk” bonds. If/when any recession questions develop it adds additional concerns relative to their ability to service their interest payments and even remain as a going concern to use pure accounting language. Historically we have seen High Yield bonds go down dramatically in comparison to Treasuries when bond market participants become more and more concerned about recession risk. It is their way of signaling recession risk is building.

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Above is a view of High Yield bonds relative to the performance of 7-10 Year Treasury bonds.  When the above line trends lower we can view this as one message coming from the bond market that it is increasing its concerns for the forward strength of the general economy.  When it falls rapidly it is an overwhelming statement that the economy is barreling toward recession if not already in one.    Left-to-right we see our first blue circle began to show some signs of weakening and then did a cliff-dive shortly after.  This was back in 2008 which led into the Great Recession as it was known.  The second blue circle showed subtle weakening which then led to a cliff-dive offering the pandemic recession.  Our third blue circle is current day with the far right corner depicting the slight change this past week.  We had seen High Yield bonds move down in price while the stated Treasuries moved up in price.  With this the line in the chart moved down in light of the weakness in High Yield’s as compared to Treasuries. We emphasize this has been subtle but felt it was time to begin monitoring the behavior of these bond market vehicles for any additional clues they may give as it relates to the forward health of the general economy. Federal Reserve Chairman Powell also chimed in last week stating that creating the proverbial “soft landing” will be quite a challenge as his Fed now prioritizes the price inflation challenge.  Soft landing is the scenario where price inflation is dealt with successfully and yet the economy continues to grow nicely. We will share more on the above type of market based signals as time moves on relative to economic recession.  At this stage it will be important to know as much in advance as to whether the economy will be able to hold up as the Fed leans into this price inflation issue with on-going interest rate hikes. I wish you well…

Ken Reinhart

Director, Market Research & Portfolio Analysis

Footnote:

H&UP’s is a quick summation of a rating system for SPX9 (abbreviation encompassing 9 Sectors of the S&P 500 with 107 sub-groups within those 9 sectors) that quickly references the percentage that is deemed healthy and higher (H&UP). This comes from the proprietary “V-NN” ranking system that is composed of 4 ratings which are “V-H-N-or NN”. A “V” or an “H” is a positive or constructive rank for said sector or sub-group within the sectors.

This commentary is presented only to provide perspectives on investment strategies and opportunities. The material contains opinions of the author, which are subject to markets change without notice. Statements concerning financial market trends are based on current market conditions which fluctuate. References to specific securities and issuers are for descriptive purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. There is no guarantee that any investment strategy will work under all market conditions. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. PERFORMANCE IS NOT GUARANTEED AND LOSSES CAN OCCUR WITH ANY INVESTMENT STRATEGY.

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