Employment, Treasuries, and Junk Bonds Indicate Trouble for Economy and Markets

by The Curmudgeon

Friday's Labor Dept. unemployment report for March was said to be a big disappointment, because only 88,000 net new jobs were created that month. But a much more disturbing fact was that about 500,000 Americans dropped out of the labor force — meaning they stopped working or looking for work. The labor force participation rate or the share of Americans ages 16 and over in the labor force, fell from 63.5% to 63.3%, a 34-year low.

That's certainly not a healthy sign for an economy that supposedly is in a recovery. In sharp contrast, the labor participation rate was approximately 65 in June 2009 when NBER said the "great recession" ended.

Labor Force Participation Rate for 2001 to 2013. Source: Bureau of Labor Statistics

Meanwhile, the 10 year T Note yield closed at its low for this year on Friday at 1.69%. That yield ranged from 3.49% to 3.94% during June 2009.

In a healthy economic recovery, intermediate term interest rates rise as there is more demand for credit and inflation premium rises. Why isn't this happening now? Answer: the U.S. has an artificial economic recovery, aided and abetted by a Federal Reserve that has kept short term rates at zero, while buying longer term government and mortgage debt. The yield on the 10 year T-Note is well below the headline inflation rate, which means the real yield is negative.

With negative real yields on short and intermediate Treasuries, investors and savers have been forced into much riskier debt investments, especially junk bonds. Junk bonds are those rated below investment grade by the bond rating agencies, and their current popularity reflects the search for yield by many investors, whose alternatives include savings accounts that pay almost nothing.

Junk bond yields have fallen to the lowest level on record. The Bank of America Merrill Lynch U.S. High Yield index yielded 5.7 % at the end of the quarter, as can be seen in the graph below. That was down from 6.1% at the end of the year, and from 8.3% at the end of 2011.

Source: Bank of America Merrill Lynch via Bloomberg

In the past, these bonds were more politely referred to as "high yield" bonds, but not anymore when they're only yielding 5%! For example, the junk bond ETF SPDR Barclays High Yield Bond (JNK) now has a 5.04% 30-day SEC yield.

“Global investors have found themselves in a situation where first cash rates were unattractive, then government bonds, then investment-grade bonds and now high-yield bonds,” Tom Becket, chief investment officer at Psigma Investment Management, said in a Financial Times article.

“People talk about opportunities in high yield because on a relative basis it looks good. At the moment the world is enjoying low inflation and we have very low interest rates, but at some point those things will change and that poses a risk.”

There have been warnings about a potential bubble in the bond market for a while. Fund managers are now warning investors that quantitative easing policies have artificially pushed up demand and prices on high-yield bonds, which have in turn put downward pressure on yields. While investors have been rewarded for taking on riskier junk bonds in the past, the current yields at around 5% no longer support the risks of default or price declines.

During the first quarter, investors poured $133 billion into junk bonds around the world, reports Floyd Norris for the New York Times. Quarterly issuance of junk bonds hit a record in the last quarter as companies sold bonds to eager buyers:

Source: Investment Company Institute

The Curmudgeon suggests that investors should keep an eye on speculative-grade corporate debt for warning signs in the credit markets that investors are losing their tolerance for risk. That would have a very negative impact on U.S. equities. It could be like the canary in the coal mine.

Till next time.....................................

The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.