Many people think all economic downturns are recessions – just mild recessions and severe recessions. Actually, there is a difference between a recession and a financial crisis. (The latter shares some characteristics with a Black Swan event.) Recessions are generally predictable events, while a financial crisis is much less predictable, like 2008. Of course, neither is a medical crisis.
When our current medical crisis began, my primary worry was that it would morph into a financial crisis and quickly concluded it would not. Naturally, there are many, many metrics to study before making such a conclusion.
My favorite metric, for predicting a financial crisis, is the “credit spread” between Treasuries and junk bonds. That means the interest rate paid on the U.S. Treasuries and the interest rate for new bonds issued by less creditworthy companies. It is measured in basis points or 100 basis points per one percentage point.
During the Great Recession in 2008, that spread reached a record 2,147 basis points or 21.47%. In other words, to issue a new junk bond then, you would have to pay 21.47% PLUS the rate on Treasuries. During the Christmas scare of 2018, the spread was 533 basis points or 5.33%. A year later, at the end of 2019, it was only 360 bp. Last month, it was up to 1,087 bps, and I was getting nervous. Today, it is a little under 800 bps. That is not great but definitely looking better. The trend is our friend.
With a worst case only half of the 2008 peak and trending down, I felt confident predicting there would be no financial crisis. Looks like I was right!