While there is a clear repricing in the market due to reduced expectations of interest rate cuts this year, equity indexes continue to make new highs. This is a result of a seemingly strong economy:

• Q1 earnings in the US were strong and showed signs of continued corporate strength.
• Growth in the services sector continues to expand, even though manufacturing is still having trouble. Services represent approximately 75% of US GDP.

However, over the past two months, we are starting to see some potential cracks in the economy:

• US Employment growth in April came in way below expectations. While one month is not a trend, it can potentially portend an increasing unemployment rate.
• Retail sales are now showing signs of slowing. If consumers stop spending, that could have two outcomes:
  • Reduce the pace of inflation (and maybe even see some deflation?).
  • Hamper economic growth (consumer spending is the most important component of US GDP).

Figure 1: US retail sales on a year over year basis continues to slow. Source: FRED.

Credit spreads refer to the extra yield or interest that must be paid to holders of corporate bonds versus holders of an equivalent government bond. For example, take a bond that matures in three years issued by a US bank. If we compare that bond to a US government bond that also matures in 3-years, we expect the corporate bond to have a higher yield. This extra yield is required to entice the bond buyer since they will be taking on the extra risk of that bank potentially going bankrupt.
We can break down corporate bonds into two categories: investment grade and high yield. Investment grade bonds are typically issued by companies with more stable financials and have a lower probability of defaulting on the debt. High yield bonds are typically issued by companies are deemed riskier, resulting in a lower credit rating and thus investors require compensation for the poorer credit quality of the issuer.

And when things start going badly in the economy, we normally start to see the initial consequences in credit spreads. This means that credit spreads tend to widen (investors demand more compensation for the extra risk) as economic uncertainty increases. If companies are navigating a tougher economic environment, they might have trouble paying the regular interest payments and paying back the principal at maturity.
Thus, keeping an eye on credit spreads is something that all investors should be doing. And unlike most economic indicators, credits spreads can be monitored for free and much more frequently.

Figure 2 shows the current spreads of investment grade bonds (in percent). You can find an equivalent graph on the Federal Reserve Board of St. Louis’s website.