Thursday, August 18, 2011

High Yield Bond Spread

Yesterday, I was happy to report that industrial production rose sharply in July, led by a big increase in auto production. This is the scenario I sketched out in early May in which a shortage of parts from Japan causes a temporary soft patch, followed by better economic growth as the parts become more available. Industrial production is one of the four components of the Index of Coincident Economic Indicators. Also encouraging is that the Index of Leading Economic Indicators (LEI) rose to a new cyclical high during June.

The yield spread between junk bonds and 10-year Treasuries is also a leading indicator. It isn’t an official one. But it should be. It is highly correlated with weekly initial unemployment claims. The monthly jobless claims series is a component of the LEI. The inverted yield spread is also highly correlated with the ECRI Weekly Leading Index.

The problem is that the yield spread has widened sharply in recent days, suggesting that the risks of a recession are rising. The spread between the Merrill Lynch High Yield Corporate Composite and the 10-year Treasury jumped from 413bps in late July to 633bps on August 11. It edged back down slightly to 608bps yesterday.


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