Beware of the Junk Bond Market

High yield bonds are not supposed to rally right along with U.S. Treasury notes. But that’s what’s been happening lately.

By Pam Martens and Russ Martens and cross-posted from Wall Street on Parade

On Friday markets digested the nonfarm payrolls report from the U.S. Labor Department showing a weak job growth in May of just 75,000. That news adds to a myriad of other economic data, including a slowdown in durable goods orders, that suggest a deceleration of the U.S. economy.

The Atlanta Fed’s closely watched GDPNow indicator is showing a very weak 1.4 percent forecast for the second quarter of this year.

The 10-year U.S. Treasury note has duly noted the deceleration in the economy and has fallen from a yield of 2.9 percent since the middle of December to 2.08 percent at Friday’s close. The yield of the U.S. Treasury has an inverse relationship to its price. That is, as the market value of the Treasury note rises, the yield declines. Thus, as the perception grows that the U.S. economy is decelerating, the value of Treasuries rises from both investor money moving out of the stock market to safe havens as well as the perception that the Federal Reserve will cut interest rates, encouraging investors to buy Treasuries now to lock in yields before they drop further.

This is Market Think 101. What is not Market Think 101 is for high yield bonds (also known as junk bonds) to rally right along with U.S. Treasury notes. But that’s what’s been happening lately.

Junk bonds are those rated below Baa3 by Moody’s and below BBB- by Standard & Poor’s. Consider this analysis of the weird behavior of junk bonds last week by Dow Jones’ MarketWatch reporters Joy Wiltermuth and Sunny Oh:

“Corporate debt rated below investment-grade, or so-called junk bonds, have made significant gains this week on surging expectations that the Federal Reserve will cut interest rates to help give steam to an economy shadowed by the prospects for a global trade war. Against this tense backdrop, the weaker-than-expected jobs report could energize bets for easier Fed policy and help bonds from leveraged issuers retrace lost ground.”

That’s not the way a rational market should think. A rational market looks out about six months and trades on what it expects to be the situation at that time. If the U.S. economy does show significant weakness to warrant a Fed interest rate cut, or multiple cuts, that means the Fed will be facing Herculean challenges: it will have only nine ¼-point interest-rate cuts in its toolkit at a time when the U.S. has the greatest amount of debt in its history

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