This Indicator Spells Trouble for U.S. Economy
You may have been led to believe that the Federal Reserve’s recent rate hike came on the heels of a recovering economy, but economic stats are indicating otherwise. If you believe the economy is safe now, you may be living in a fool’s paradise. This one serious, imminent threat could lead to a U.S. economic collapse in 2016.
Money managers are now predicting that the U.S. economy is headed for a recession, with a 44% probability of it happening this year. (Source: “Junk Bonds Signal 44% Recession Risk in 2016, Fridson Says,” Bloomberg, January 12, 2016.)
The premise for this theory is the increasing junk bond yield spreads. How are they calculating this probability? By taking the current yields on junk bonds and plotting them between the average lows seen through the expansionary period and the average highs seen through the last recession.
Simply put, junk bonds are high-yield bonds in that they offer high interest rates to cover for their high credit risk. Treasuries floated by the government are, on the contrary, considered risk-free.
The spread between Treasuries and junk bonds defines how risky the market is. An increase in spread means the junk bonds are becoming riskier—in other words, the corporations issuing these bonds are now more likely to default on their debt payments. Decreasing spreads, on the contrary, indicate improving credit worthiness of these corporations.
Now, recall what led to the financial crisis of 2008. Sparing all the financial jargon on credit default swaps (CDS), collateralized debt obligations (CDOs), and mortgage-backed securities (MBS), let me make it simple for you. In a nutshell, creditors were lending money to debtors who could not process their obligations. Ultimately, this led to a major collapse in the banking and housing markets. Déjà vu?
Expect More Bankruptcies!
If you understand this concept, let me now relay the seriousness of this matter.
This year’s first and biggest bankruptcy has already been announced. One of the largest coal producers in the U.S. has filed for Chapter 11 bankruptcy this Monday, sending shockwaves across the commodity market. (Source: “Arch Coal Files for Bankruptcy; Coal Default Rate at ‘Unprecedented’ 43%,” Barron’s, January 11, 2016.)
The fears are genuine. If the downward trend in commodity prices continues, Arch Coal is going to be the first of the many bankruptcies that are going to follow on the heels of slumping oil, natural gas, and commodity prices.
Notice how all the big guns in the commodity and mining business are gasping for air on the stock market as they struggle to stay afloat. Freeport-McMoRan Inc. (NYSE:FCX) has plummeted more than 80% in the last one year. Peabody Energy Corporation (NYSE:BTU) has lost more than 95% value. Alcoa Inc. (NYSE:AA) is down about 54%. CONSOL Energy Inc. (NYSE:CNX) has shed about 78% of its shareholder value.
Supporting this theory is Standard & Poor’s, which is predicting corporate default rates to rise to 3.3% by September of this year, compared to 2.5% a year ago. (Source: “U.S. Companies Led the World in 2015 Debt Defaults, S&P Says,” Bloomberg, December 28, 2015.)
Standard & Poor’s prediction supports the stats it released last month, according to which U.S. corporations led 60% of the total global corporate defaults in 2015.
This should scare not only the bondholders, but also the stockholders of these corporations that continue to prop up share prices via debt-backed share buybacks and acquisitions, without adding any tangible value to their businesses.
Notice that the Dow and the S&P 500 fell by more than six percent in the first week of the New Year. While part of this decline has been recouped in the following days, the decline is still significant. We may blame the Chinese markets for this turmoil, but the fact is that U.S. corporations are not faring any better this year.
Argue all you want, but the fact remains that the rising yield spreads raise red flags on the U.S. economy that could be headed for an economic collapse in 2016.