Are Bonds Suggesting the Economy Will Get Much Worse?

New research shows corporate bonds have been far better at predicting where the economy is headed than anyone thought…In the fall of 2007…. corporate-bond prices were signaling all was not well.
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In a forthcoming paper in the Journal of Monetary Economics economists Simon Gilchrist and Vladimir Yankov at Boston University, and Egon Zakrajsek at the Federal Reserve 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.

The article notes bonds’ forecasts haven’t always seemed to come true. Many corporate-bond indexes showed spreads widening significantly during the 1998 Russian debt crisis, and yet the economy soldiered on. [via WSJ]

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