Most people are overly-fearful of recessions and shouldn’t be. Garden-variety recessions are routine. They come and go. The danger is that a garden-variety recession might morph into a financial crisis, which is much worse.
We are certainly in a recession right now. (In fact, it is a totally unique “flash depression,” which sounds worse than it is.) The risk is that this recession might also morph into another financial crisis, like 2008/9. Obviously, I watch this risk closely.
My favorite measure of that risk is credit spreads – the excess cost of credit relative to risk-free Treasury bonds. An increasing credit spread suggests increasing stress in our financial system. For example, corporate bonds pay about 135 basis points (1.35%) more today than Treasury bonds. That’s because corporations have more risk than the U.S. government. Now, compare 135 bps with long term average of 149 bps. At the worst of the pandemic panic in March, that spread was 401 bps. This indicated increased stress in our financial system, which was somewhat worrisome at the time. In December 2008, the credit spread for corporate bonds was a whopping 622 bps.
A different measure is the spread between Treasuries and High-Yield bonds, more commonly known as junk bonds. Reflecting greater risks, that spread is now about 526 bps, slightly higher than its long term average of 494 bps. In March, it was 1,087 bps but was a whopping 2,147 bps in December of 2008. Therefore, no cause for alarm today.
Bottom Line: Credit spreads are not excessive and do NOT indicate an approaching financial crisis.
