ARE CREDIT SPREADS "THE DOG THAT DIDN'T BARK?"
I became a Sherlock Holmes fan at 11 years old, when a helpful school librarian pointed me towards Arthur Conan Doyle’s stories of the great detective. One story, “Silver Blaze,” had an innovation that is often used as a metaphor. In that story, one of the most important clues was (spoiler alert!) something that didn’t happen. A dog didn’t bark when the crime was committed. The absence of this event helped solve the crime.
These days, the markets have been in turmoil with high inflation, potential acceleration from central bank action, and geo-political uncertainty in Eastern Europe. During this time, the VIX and MOVE indices have soared. An increase in implied volatility for both equity and bond markets has historically been a harbinger of financial instability. Everyone agrees that equity market valuations are stretched, particularly in the tech sector. Bubble markets like cryptocurrencies are crashing.
Despite all the turmoil, one reliable risk factor is curiously silent: investment grade credit spreads. While corporate bond yields have risen in parallel with treasury yields, the spread between Moody Aaa/Aa and Baa corporate bond yields has been remarkably stable and narrow. This implies that the risk of default, an important indicator of economic and financial instability, is largely being discounted by the corporate bond market. The last time credit spreads remained quiet while equity market volatility rose was 1997, during the emerging market currency crisis. That was also a turbulent time but the markets recovered quickly.
It’s possible that the credit markets are saying, through their silence, that the current bout of market uncertainty is also temporary. Let’s hope so. Certainly investment grade spreads are something we should be keeping an eye on.
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