New research shows corporate bonds have been far better at predicting where the economy is headed than anyone thought. Unfortunately, that suggests the economy is going to get much worse.
In the fall of 2007, before the economy began to falter, corporate-bond prices were signaling all was not well. The spread between corporate-bond yields and Treasury yields, which had begun to widen amid that summer's mortgage woes, showed little improvement even as the Dow Jones Industrial Average clocked record highs.
In a forthcoming paper in the Journal of Monetary Economics they show that spreads on low- to medium-risk corporate bonds, particularly those with 15 or more years until maturity, predicted changes in the economy phenomenally well, forecasting the ups and downs in both hiring and production a year before they occurred. Since writing the paper, they extended their analysis back to 1973 and found bonds' predictive ability still held.
It would be better for everyone if it doesn't hold in the future. With the massive widening in corporate-bond spreads last fall, the economists' model predicts industrial production will fall another 17% by the end of the year, and the economy will lose another 7.8 million jobs on top of the 5.1 million it has shed since the recession began. Ouch.