Moody's Credit Markets Review and Outlook: Bullish Default Rates and Treasury Yields

Moody’s is one of the big three credit rating agencies besides Standard & Poor’s and Fitch Group. Investors around the world look to Moody’s to properly assess the financial health of U.S. companies and therefore the risk in U.S. equities. The well-respected organization also posts weekly reports and analysis on various rates and credit data. Weekly, it outlines the biggest issues in the credit and risk in its “Credit Markets Review and Outlook” typically written by its chief economist, Jon Lonski.

This week, the report highlights some dynamics in the equity market that show some sensitivity to certain indicators in the credit market. Since the beginning of 2018, the market has been relatively volatile coming off highs in late January. The worst seems to be over, but the S&P 500 appears to be locked into a trading range. Moody’s analysis suggests the market will resume its growth based on falling default rates.

Moody’s states that “roughly 88 percent of the 209 year-over-year declines by the high-yield default rate since June 1985 have been accompanied by a yearly increase in the market value of U.S. common stock.” It’s a sensible, straightforward causal relationship. When fewer companies are failing, either because debt is lower than usual or profits are higher than usual, investors are willing to invest in riskier equities. Moody’s points out that the medians in this sample are a 1.5 drop in default rate and a 13.4 percent increase in equity value

While falling default rates is a generally positive indicator for equity valuation, higher Treasury yields can put some pressure on the bullishness. Moody’s cites two examples in 1987 and 1994 where a drop in the default rate was accompanied by a large year-over-year increase in the 10-year Treasury yield and equities ultimately fell. Despite an increase in operating income, the market saw skyrocketing borrowing costs and a repellent from equities. Rising government debt yields is also a sign of a central bank tightening which is a well-known bearish signal for equities.

Moody’s also noted that securities related to the housing sector have underperformed because of the noticeable increase in bond yields. In particular Moody’s mentions, PHLX’s housing sector index is 18.3 percent off its early 2018 highs and high-yield bonds related to housing lags the rest of the high-yield bond market by about 1.8 percent.

Halfway through the year, Treasury rates drop from yearly highs but threaten to rise again. With the passing of the 3 percent level making headlines, Moody’s suggests that the market will have trouble sustaining rates above 3 percent and even more difficult around 3.2 percent. Instead, it sees a softer advance in the 10-year yield and falling default rates as a bullish signal for equities. Of course, the onus still lies with the Federal Reserve to indicate where it wants rates to go. Meetings in June and July will be well-watched. Almost certainly will those events be eyed in future editions of Moody’s “Credit Markets Review and Outlook.”