One of the beauties of a free market system is the information that individuals can learn from signals, such as price or demand, without a centralized source having to know everything and communicate that to everyone. But what information are investors, traders, and I guess, anyone, supposed to garner from markets that are irrepressibly manipulated by central banks? In a Wall Street Journal article last week, BNP Paribas reported that “at current levels, the high-yield market is pricing in a 56% probability of recession.” Many other investment banks have touted similar projections citing the widening spread that is developing between junk bonds and U.S. Treasuries. In a market absent central bank intervention, I would concur with those assessments. However in the U.S. and Eurozone debt markets, where central bankers have a heavy hand, how can one possibly draw conclusions?
Prices are the necessary information market participants require to make appropriate purchases, sales, investments, and any and all capital allocations. Market participants closely watch the spreads between bonds to make these decisions and at present they are somewhat alarming.
High-yield junk bonds are yielding north of 8% while the 10-year Treasury note yield continues to hover just above 2%. That’s a 600+ basis point spread. By comparison, during the financial crisis, junk yields in late October 2008 were yielding north of 18% while 10-year treasuries were yielding about 4%. That’s a 1,400 basis point spread. Usually junk bonds yield 450 to 500 basis points more than the 10-year treasury, and anything above 600 basis points typically is a signal for rough times ahead. Anything above 1000 basis points almost always means recession.
So, should market participants heed the warning that economic woes are on the horizon, make necessary arrangements for a probable recession, and invest appropriately so as to avoid the mistakes many investors and business developers made in the fall of 2008? Maybe, maybe not. It’s impossible to act on information that has been manipulated to the point of being meaningless.
In a free market, participants would be able to make decisions based on this spread, because the prices would reflect the current investment environment. But these prices are manipulated. Participants now need to focus on the Federal Reserve and the European Central Bank (ECB) to make necessary investment, development and hiring decisions. Yields on Spanish, Italian and Irish debt have made extraordinary moves that would otherwise provide pertinent information to potential investors and businesses looking to do business. The yield on the 10-year Italian and Spanish bonds fell from 6.2% and 6.4% respectively to 4.9% in the month of August alone. Irish 10-year bond yields fell from a high of 14.1% in the middle of July to 8.6% yesterday. These are huge swings. But how much of those declines were as a result of ECB intervention as opposed to a market driven reduction in the fear of sovereign defaults? It is unlikely they would have dropped at all without the presence of the ECB. The same questions are being asked about Federal Reserve intervention and the current bond spreads in the U.S.
Businesses and investors should not have to ask these questions. Those that are questioning current market signals, and rightly so, are stalling investment and development decisions because of the presence of imperfect information. Those that are acting on the information may be misappropriating money and making malinvestments. For instance, if BNP Paribas looks at the yield on the 10-year Treasury currently at 2% and sees the more than 600 basis point difference between it and junk bonds, they may choose to make more conservative investments, or may choose to actually liquidate business ventures and other investments because of the market signaling recession. If 10-year Treasuries should truly be yielding closer to 3% or possibly even 4% or 5% as many bond investors believe, then, they should actually be investing heavily and hiring.
Central banks have had a hand in markets before. This is nothing new. Investors and businesses have always had to pay attention to their actions as they are presently doing now; however, the degree to which the Fed, the ECB, and others are currently manipulating markets is unprecedented historically. In the past, they were acknowledged as an element of the market, a factor affecting decisions at the margin, just another player to keep an eye on. Now, they are the market. Their interventions are now so large that prices move on their actions to extremely skewed levels, not simply marginal increases or decreases. Fundamentals need not apply.
Making investment and business decisions is difficult enough in a free market. Making them in today’s markets is simply not possible. Americans often hear of the uncertainty businesses and investors are facing, but don’t quite realize just how great that uncertainty affects their lives. Without the proper pricing signals that central banks are currently distorting, businesses and investors cannot move forward. Those that choose to base decisions off of today’s manipulated prices will be proven fools, unless of course their mistakes once again are bailed out.