Wednesday, June 08, 2005

Of spreads and stocks

As if the long-term rate conundrum weren’t enough, I’m afraid we have another puzzle on our hands, this time related to the behavior of bond spreads and stock prices.

Spreads –in this case the difference between the yields of Baa-rated bonds and 10-year Treasuries--are usually high during recessions or periods of slow growth and tend to fall in more prosperous times. They aren’t correlated with the level of rates, but they do show a strong negative response to changes in rates: that is, spreads rise when rates fall and vice versa. The cause is clear: falling rates imply lower expected inflation, which in turn reflects slower growth in the economy and a lower earnings performance in firms.

The following graph shows normalized (i.e. long term average =1) 10-year yields and Baa spreads.

img src="">.

A few brief observations:

· After 2000, spreads went wild, reaching never before seen heights despite the fact that the 2001 recession was pretty mild. This probably reflects structurally higher leverage.
· Despite robust economic growth in 2004/2005, spreads are still pretty high relative to the long run average.
· As was to be expected, spreads have risen sharply in the past few weeks, in tandem with falling long-term rates.
· Spreads will only fall to long-term average levels if rates rise towards 5%.

The central message here is that the recent fall in rates is not good news, as it signals a weaker economy that will lower credit quality and raise the level of financial risk.

However, it’s worth noting that stocks in the U.S. have posted gains in the last two months, a period in which spreads rose sharply. Needless to say, this is contradictory: stocks usually move in the opposite direction of spreads.

So who’s right? I honestly wished I did. The only thing I do know is that we live in very uncertain times when traditional correlations are not working as expected. Hence, I’d have a very cautious investment policy. Cash anyone?