Are Markets Pricing in a Recession?

At LPL Research, we analyze a number of different markets to try to determine what markets are pricing in in terms of earnings expectations, default expectations, and different economic scenarios. In this edition of the LPL Street View, Fixed Income Strategist Lawrence Gillum looks at two different fixed income markets to try and determine if markets are pricing in an imminent economic recession.

LPL Research is constantly watching markets, and as market-watchers, we try to glean what markets are pricing in in terms of the probability of certain events happening. And there are two very important markets within the fixed income markets when it comes to determining the expectations of an economic recession: the U.S. Treasury market and the U.S. high yield corporate credit market.

The shape of U.S Treasury yield curve is often looked at as a barometer for U.S. economic growth. More specifically, it reflects how the Federal Reserve (Fed) intends to stimulate or slow economic growth by cutting or raising its policy rate. In “normal” times, the yield curve is upward sloping, meaning longer maturity Treasury yields are higher than shorter maturity Treasury yields. However, when the economy is growing too quickly, inflationary pressures are apparent, and the Fed wants to slow growth, shorter maturity securities could eventually out-yield longer maturity securities, inverting the yield curve. An inverted yield curve has been a pretty reliable predictor of economic recessions. Over the past six months, the Fed has been aggressively raising short term interest rates in an effort to arrest these continued consumer price increases and to slow the economy.

When look at the yield curve currently, we see the 2-year yield is out-yielding the 10-year Treasury yield and is thus inverted. Maybe more concerning though is that the 3M/10Y part of the yield curve is getting close to inversion as well. The 3M/10Y parts of the yield curve have more academic backing in terms of the signal that they provide. Economic recessions have occurred shortly after these yield curve inversions have taken place. So, the signal that we’re getting from the interest rate markets is maybe a recession is on the horizon. However, rarely do we only rely on one market as a definitive signal, so we next turn to the other important fixed income market, and that’s the U.S. high yield corporate credit market.

The U.S. high yield corporate credit market can act like a canary in the economic coalmine. The return distribution for high yield investors is asymmetrical, which means the potential for losses can be magnitudes larger than the potential for gains. So, credit markets tend to react quickly when economic conditions start to deteriorate. And when we look at the signal coming from the high yield corporate credit markets, we aren’t seeing the same level of concern for an impending economic recession. Credit spreads, or the additional compensation for owning riskier debt than Treasury securities, have risen lately, but we haven’t seen them rise to the same levels that previously signaled a recession was on the horizon. In fact, when we look at spreads currently, they’re only back to that average level over the past 20 years. Spreads have tended to widen out to around 700 basis points or so whereas we’re currently at 460 basis points, which again is roughly the longer term average spread to Treasuries.

So, what’s the takeaway? When we have two slightly different market signals, we think it best to listen to both of course, but because we are getting different signals, we don’t think markets are expecting a recession in the near term. That said, as the Fed continues its aggressive rate hiking campaign to stamp out these high inflation rates by deliberately slowing the economy, we do think recession risks have increased. We think a soft or softish landing is still possible but right now we think it’s a 50/50 proposition that a recession occurs sometime in 2023. But we’ll be watching markets closely for signals that those risks change.

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