The Potential Impact of Bond-Market Reality on Investors’ Expectations of a Soft Landing

The Potential Impact of Bond-Market Reality on Investors’ Expectations of a Soft Landing

In the world of investing, it’s often said that when everyone thinks alike, everyone is likely to be wrong. This sentiment holds true when it comes to the current state of the bond market and investors’ expectations of a soft landing for the economy. Contrarians believe that the abnormally low “junk spread” – the difference between the yield on corporate high-yield bonds and U.S. Treasurys – is a sign of excess exuberance that will correct itself in the coming months.

The junk spread currently stands at 3.5 percentage points, well below its historical average since 1997 of 5.4 percentage points. This indicates that investors believe economic risk is low, thanks to the perceived success of the U.S. Federal Reserve in achieving a soft landing. However, contrarians warn against complacency, citing the words of Humphrey Neill, the father of contrarian analysis: “When everyone thinks alike, everyone is likely to be wrong.”

To support their belief in an imminent correction, contrarians look to historical data. The chart provided shows the significant differences in the junk spread over time, with the current spread falling in the lowest historical quintile. This suggests an elevated risk of a recession. According to statisticians, these differences are significant at a 95% confidence level, further supporting contrarian concerns.

Contrarians argue that increases in the junk spread of 1.9 to 4.8 percentage points over a one- to two-year period would not only reflect increased economic risk but also contribute to that increase. This is why they believe the junk spread should be added to the set of sentiment indicators used to assess investor mood. Unlike most other sentiment indicators that provide insights for only a one- to three-month horizon, the junk-bond spread has greater explanatory power in the one- to three-year horizon.

While this longer explanatory horizon might provide some solace, it also suggests that the heightened risk of a recession is not going away soon. Contrarian theory aligns with the possibility of a recession beginning just as the market celebrates a soft landing. This analysis does not guarantee a recession, but it serves as a warning to investors not to become too complacent.

Mark Hulbert, a regular contributor to MarketWatch and expert in investment newsletters, emphasizes the importance of considering all indicators and taking a cautious approach in the current market environment. The stock market’s “bad breadth” is causing even stalwart bulls to become nervous, and investors should be prepared for what lies ahead.

As we enter February after a strong rally in January, it’s crucial for investors to be aware of the potential impact of bond-market reality on their expectations of a soft landing. By considering contrarian perspectives and closely monitoring the junk spread and other sentiment indicators, investors can position themselves more effectively in these uncertain times.