Stock, Bond, Commodity Markets All Signaling Recovery, Part 2

Let’s take a look at one kind of bond compared to another. Instead of a difference between the earnings of stocks and the interest rate (the way bond investors get paid) of treasury bonds, let’s take a look at the difference between corporate bonds and treasuries. Since corporate bonds do not have the full faith and credit of the U.S. government, they are considered more risky, so the difference between the interest rates of corporates and the interest rates of treasuries are a measure of risk expectations.

Here’s what that data look like over time:

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(Source: Federal Reserve Bank of St. Louis, as of August 2020)

It’s easy to see now spikes coincided with the recession of 2001, the Great Recession, The European Debt Crisis (though that was kind of a slight spike), and the Pandemic Panic. And it is also easy to see how this risk metric has been falling from its peak in March through the end of Q2 2020.

This is a signal of greater optimism in the form of more confidence that corporations will pay their obligatory interest amounts.

Below, let’s rearrange things so that the bottom axis no longer reads from earlier to later, but now reads from most optimistic to least optimistic. The up/down axis shows subsequent one-year economic growth.

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(Source: Federal Reserve Bank of St. Louis, as of August 2020)

Clearly there is a negative correlation, which means that when the fear metric is higher, growth tends to be lower; and when the fear metric is lower, growth tends to be higher. Of course, that makes perfect sense. The markets are not perfect, otherwise there would be a perfect straight line of dots sloping downward. But clearly the markets tend to get the direction right much of the time.

What were they signaling as of this data? Growing optimism and roughly 2% annual growth in the following year. This is not a sure thing, but it is another piece of evidence showing that markets are expecting recovery.