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The secular decline by Treasury bond yields since 1982 has been accompanied by a secular climb in the ratio of private and public non financial-sector debt to GDP. Basically, as benchmark interest rates have declined to help maintain a satisfactory pace for business activity, the private and public sectors have assumed more debt relative to underlying expenditures. Furthermore, as indebtedness increases relative to the business activity that funds debt servicing obligations,less of an increase in benchmark interest rates is required for the purpose of warding off an inflationary pace of spending growth. Also reinforcing the bias toward lower interest rates would be how deeper declines by benchmark interest rates may be required for the purpose of significantly enlivening business activity at higher ratios of total debt to GDP.As the 10-year Treasury yield’s moving yearlong average sank from second-quarter 1982’s record-high 14.29%to the 0.89% of 2020’s final quarter, the moving yearlong ratio of total U.S. private and public non financial sector debt to GDP climbed from 143% to a record 283%. Prior to COVID-19, fourth-quarter 2019's ratio equaled 250%.
Needless to say, both U.S. business activity and financial markets would suffer greatly if an exogenous force propelled benchmark U.S. interest rates sharply higher.
The first year of a U.S. business cycle upturn has been underway for some time. Add to that: (i) U.S. corporate credit rating revisions showing far more upgrades than downgrades, (ii) the now much greater number of improved corporate credit outlook changes compared to diminished outlooks, (iii) historically thin corporate bond yield spreads, and (iv) the lowest high-yield expected default frequency metric since mid-2007. All testify to the presence of a corporate credit cycle upturn.
Corporate credit quality tends to improve when core pretax profits grow more rapidly than corporate debt. And in the early years of each business cycle upturn since 1982, core profits have far outpaced corporate debt. In turn, corporate bond yield spreads have narrowed, and default rates have dropped in response to the post recession episodes of a much faster rate of core profits growth relative to corporate debt growth. As long as this constructive imbalance is expected to hold, yield spreads should be under their long-term averages.
A post-recession acceleration of corporate debt may not obviate a narrowing of corporate bond yield spreads if accompanied by an even faster acceleration of core profits. The calendar-year average of a composite high yield bond spread narrowed from 1983’s 329 basis points to 1984’s 290 bp despite an acceleration by the annual average growth rate of nonfinancial-corporate debt from 8.6% to 14.4% mostly because of an accompanying acceleration by core profits growth from 21.5% to 27.7%.Nevertheless, corporate credit quality is better served when corporate debt shrinks outright amid core profits growth. And that is precisely what occurred following the recessions of 1990-1991, 2001, and 2008-2009.
However, the expansion of nonfinancial-corporate debt is likely to continue during the early years of the unfolding business cycle upturn largely in response to extraordinarily low corporate borrowing costs and the sense that monetary and fiscal policy will do whatever is necessary to extend the upturn until full employment takes hold. Because of the release of pent-up demand and the application of massive monetary and fiscal stimuli, the credit market is confident that a disruptive contraction of core profits will be avoided for sometime. Thus, today’s historically narrow corporate bond yield spreads may persist for some time.As inferred from FactSet consensus expectations of at least a 20% annual advance by 2021’s S&P 500 earnings per share, both corporate earnings and cash flows should significantly outpace corporate debt and by doing so enhance corporate credit quality in 2021.
Seasonally adjusted retail sales soared 9.8% monthly to a new record high in March. Not only were March retail sales up 27.7% from March 2020’s COVID-19 depressed pace, they also expanded at a blistering 9.9%average annualized pace from March 2019’s tally. Reason to believe that a brisk pace of retail sales will be maintained was inferred from the deep drop by initial state unemployment claims from April 3’s 769,000 first time filings to April 10’s 576,000.Nevertheless, you would never know that it is housing’s peak spring selling season according to April 9’s third straight week-to-week decline by the Mortgage Bankers Association’s index of mortgage applications for the purchase of a home. The average of the four-weeks-ended April 9 showed that homebuyer mortgage applications were a considerable 14.3% under their latest peak moving four-week average of the span-ended January 29.Flat-to-lower homebuyer mortgage applications suggest that the consensus may have overestimated 2021’ space for home sales. The surprisingly muted pace of homebuyer mortgage applications might partly be ascribed to higher mortgage yields. After bottoming at the 2.96% of the span-ended January 1, 2021, themoving four-week average of the MBA’s effective 30-year mortgage yield has since risen to 3.44% as of thespan-ended April 9.A possible loss of anticipated credit-sensitive expenditures to higher interest rates partly explains why the recent 1.55% 10-year Treasury yield is under March 31’s current cycle-high of 1.74%. More than inflation expectations determine Treasury bond yields.According to some, under-appreciated geopolitical and pandemic risks help to explain the odd juxtaposition of lower Treasury bond yields amid very upbeat outlooks for business activity and corporate earnings.
Supposedly, increased foreign buying of U.S. Treasury bonds is responsible for the unexpected drop bybenchmark bond yields.
The most heavily traded lumber futures contract set a new record high on April 14. Compared with its COVID-19 suppressed reading of a year earlier, lumber futures are up by a staggering 277% year-to-year.In order to eliminate the downward bias now implicit to many year-to-year comparisons, current prices and levels of business activity might be measured off of their levels of two years back. But even this approach shows an 89% average annualized advance by lumber futures over the past two years.
Depending on the time frame, the price of WTI crude oil may or may not exhibit very rapid growth.April 14’s price of WTI crude oil soared higher by 178% yearly. However, in order to limit the downward bias emanating from the COVID-19 recession of a year earlier, the price of WTI crude oil incurred a far different looking 1% average annualized decline over the past 24 months.In a similar manner, April 14’s price of the most heavily trade gasoline futures contract went from being up201% year-to-year to a 1% average annualized rise compared to 24-months back.
It was nearly 36 years ago that I penned my first weekly commentary for what was then Moody’s Bond Survey.Since I’ll be moving on, this is my final installment. I would like to thank my editors and production staff for their assistance over the years and Moody’s management for this opportunity. And, of course, I’m grateful to you readers for using your valuable time to see what I had to say. For the employees of Moody’s Corporation and you readers, I predict the best is yet to come. By the way, I’m not vanishing and can be reached via LinkedIn.
