What Everyone’s Watching

It’s no secret that the financial markets have been volatile in 2018, especially since October 1st.  While the trade war with China and the Federal Reserve have been the focus this year, Wall Street has turned its attention to yield spreads.

Yield spreads are just what they sound like.  They are the interest rate spread between high yield bonds and treasury bonds.  Investors watch this to see if there is any stress in the financial system.  When the spread widens, typically there’s either an economic issue and/or a stock market correction.

In the last few weeks, the yield spread has started to widen.  It’s the topic du jour.  And, it’s definitely worth watching.  But, let’s put it into context.

Currently, the spread is 4.19%.  As you can see from the chart, this had been hovering around 3% from most of 2017 and 2018.  So, it’s starting to move.  For comparison, in 2015 and early 2016, the spread was over 7%.  In 2011, again, it was over 7%.  In 2008 during the financial crisis, it was over 19%!  So, it’s still very low.  But, investors tend to care about the direction rather than the absolute value.  This is why everyone’s freaking out about the Federal Reserve raising rates to 2.5% when several years ago we would have thought that was a low level.

The current level of the yield spread is not concerning, but we don’t know where the spread will end up.  Currently, there have been some indications in the last few weeks that the economy is decelerating.  Investors seem to sell first and ask questions later.  A deceleration is very different from a recession and a recession is very different from a financial crisis.  We’ve had a few cyclical slowdowns (deceleration) since 2008 without having a recession.

As you can see from the chart, each time yield spreads widen, stocks struggle for a while, and eventually cooler heads prevail.

Yield Spreads

 

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