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What Are The Credit Markets Telling Us?

The stock market rallied Wednesday when the Federal Reserve implemented its well-advertised interest rate boost. This seemed to support the Fed’s conclusion that the U.S. economy, after nine years of crisis-induced palsy, is finally getting back on its feet.

But elsewhere in the financial markets there are symptoms of incipient relapse. It might be just a passing bit of vertigo, but then again, it might not.

The collapse in oil prices over the past year is probably the most obvious sign of trouble afoot, but it is not necessarily the most important. After all, if the drop from more than $100 per barrel of crude to less than $40 is really just a symptom of excess supply, it would probably be good news overall. This is because all of the world’s leading economies are net consumers, not net producers, of crude - even here in the United States amid the production boom that accompanied the expansion of hydraulic fracturing and other advanced drilling techniques.

Perhaps more telling is the virtual disappearance of the spread between U.S. and global crude prices. Not long ago, West Texas Intermediate - the benchmark grade for domestic oil - routinely sold at a discount of $10 to $15 a barrel compared to Brent crude, the global reference price and the one that dominates trade abroad. This made sense. A four-decade ban on exports of U.S. crude prevented our oil from reaching most foreign buyers unless it first passed through an American refinery, so our production boom did very little to meet demand in Europe or Asia. But this week, the spread between West Texas and Brent shrank to less than $1.

This might be because a budget agreement in Congress seemed poised to eliminate the export ban. But since the spread has been shrinking all year, it is more likely because overseas demand is drying up due to stagnant economies stretching from Spain to China. U.S. manufacturing has likewise been taking it on the chin. A strengthening dollar has made our products more expensive for foreign customers, hurting exports. Farmers are feeling a similar pinch. And the oil drilling industry, after defying gravity during the first half of 2015, has finally accepted the reality of lower prices and is slashing payrolls and drilling budgets.

These are not harbingers of economic strength.

Yet the most vivid caution signs are coming from the credit markets, specifically the part that is sometimes rudely called “junk bonds.” This sector likes to call itself “high yield.” The most apt term might be “high risk.”

It isn’t just that the price of debt issued by lower-rated (or unrated) companies has plunged; it is that the demand for some of those debt issues has virtually dried up even at the newly depressed prices. The problems may have started in the energy sector, but they have rapidly expanded well beyond it.

The fallout has already been dramatic. Earlier this week a mutual fund, the Third Avenue Focused Credit Fund, suspended withdrawals and announced that it will liquidate. The process will be slow; it may be months, perhaps many months, before the fund’s investors receive all their capital. Mutual funds ordinarily send redemption money in one day.

The initial reaction was to view Third Avenue Focused Credit as an outlier, because the fund had unusually high concentrations of assets in the bond market sectors that have been hardest hit. Moreover, some observers claimed the fund was being targeted by traders who deduced its holdings and pushed prices down on the theory that the fund would be forced to conduct a fire sale to meet redemption requests. The drawn-out liquidation is intended to let the fund eventually get better prices for its investors, and so it might.

But the mutual fund was not so much of an outlier. At least three hedge funds have also recently imposed restrictions on redemptions, also to avoid having to sell assets at distressed prices. While hedge funds have greater contractual leeway to close these so-called gates, they have seldom had reason to exercise that power since the darkest days of the financial crisis seven years ago. All of the funds in question - the Carlyle Group’s Claren Road fund, Stone Lion Capital Partners L.P. and Marin Capital Partners L.P. - were active in the corporate bond space, although Marin’s specialty was bonds that could be converted to equity.

Sure, there are explanations for why these particular funds ran into trouble. But those explanations will sound like rationalizations if it turns out that investors are getting too anxious to pull their money from companies with weaker balance sheets. This is what often happens when the market senses that the economy is approaching a recession. And in this country, recessions usually happen after the Federal Reserve begins a cycle of tightening interest rates.

Not all bond market plunges, and not all interest rate tightening efforts, are followed by recessions. There were significant shocks in the credit markets when the Fed tightened the reins in 1994. The following year the stock market started a spectacular five-year bull market, and the economy continued to grow without interruption all the way to 2001.

Still, despite the Fed’s confidence that the economy is ready for a long-delayed dose of normalcy in interest rates, and despite the stock market’s aplomb when the move finally came, I would not be too quick to disregard the other corners of the financial markets that are telling us the economy may not be as robust as we think. Recessions are not the end of the world, and I would not panic if one came along in the next year or so. I wouldn’t be surprised, either.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us” and Chapter 4, “The Family Business."

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