Which brings us to our two big risks today. The first is that interest rates, though still low by pre-crisis standards, are starting to get a little high by our post-crisis ones. In fact, the best recession predictor we have — the difference between the government’s 10-year and two-year borrowing costs — is beginning to flash yellow.
Why does that tell us so much? Well, it has to do with the economic story that’s embedded within longer-term interest rates. Those, you see, show us what markets think short-term interest rates are going to average over that time, plus a little extra to make up for the risk that inflation ends up being higher than people thought it would. So when long-term rates are lower than short-term ones, what’s known as an “inverted yield curve,” it’s telling us that markets think the Federal Reserve is going to have to stop raising rates and start cutting them in the near future. And when would it do that? Easy: when it’s trying to fight a recession.
The good news is that this hasn’t happened yet, but the bad news is it probably won’t be long until it does. Not when 10-year interest rates are a mere 0.25 percentage points above two-year ones. All it should take is another rate hike or two for it to invert, at which point, if history is any guide, we could expect a recession within the next year or so. Right around, you guessed it, 2020.
So far, so normal. Higher borrowing costs are always a threat to the economy. They slow down the housing market, which usually slows down consumer spending as well, and, as a result, hurts profits enough that companies either slow down their hiring or maybe start laying people off. What makes them an even bigger threat right now, though, is the other problem that’s pretty plain to see: all the money that companies have borrowed over the past 10 years.
Indeed, as Bloomberg Opinion’s Noah Smith points out, nonfinancial corporate debt has just hit an all-time high as a share of the economy. And, as you would expect when so many loans are being made so quickly, a lot of it looks quite risky. Companies that already have a lot of debt have been some of the biggest borrowers recently in the so-called “leveraged loan” market — which is now up to a total of $1.3 trillion. Despite that, though, there’s been so much competition among lenders to make these loans that they haven’t been requiring a lot of protection for themselves if things go bad.
In a certain foreboding sense, that’s understandable. That’s because, by and large, they aren’t holding onto these loans themselves but are rather bundling them together into securities known as “collateralized loan obligations” (CLOs) to sell to investors. That, thanks to the magic of modern finance, lets them turn a big chunk of their BBB-rated corporate loans into AAA-rated bonds, since there should be safety in numbers: Any single borrower might default, but the chance that most of them would at the same time should be negligible. At least it is according to their mathematical models, which, as we know, are never . . . never mind.
All of this should sound uncomfortably familiar. After all, replace “businesses” with “households,” and you’d have a pretty good description of what went wrong in 2008. Just as before, lenders are stretching the definition of “creditworthy” to include anyone who wants to borrow money in an attempt to make — and then sell — as many loans as possible. And also as before, it’s not always banks but, rather, unregulated lenders like hedge funds and private equity firms that are the ones doing this. Which, if it weren’t bad enough, just got worse, thanks to a new loophole courtesy of the conservative judges at the U.S. Court of Appeals for the D.C. Circuit. As my colleague Steven Pearlstein points out, they decided to exempt the non-bank entities that slice and dice these loans together from the post-crisis rules that required them to hold on to at least 5 percent of them themselves as long as they weren’t the ones who had made the loans in the first place.
Now, that’s not to say that this will end as badly as things did in 2008, but it’s not exactly the highest of bars to say that we’ll avoid a repeat of the worst financial crisis in history. That still leaves plenty of extremely unpleasant possibilities for the corporate debt market, which the International Monetary Fund, former Fed chair Janet Yellen and even hedge fund managers like Paul Tudor Jones have all been sounding the alarm over. What we can say is that companies will probably face higher debt payments right when they’re dealing with lower profits — that is, when interest rates really are getting high — to the point that a few might end up defaulting. How bad would that be? That’s hard to say, as it would depend in large part on who was bearing those losses, how well they were able to do so, and how important they were to the financial system as a whole. But at a minimum, these kind of corporate defaults would probably be enough to send an economy whose virtuous circle was looking a little wobbly into a vicious one instead.
Just because a problem is obvious doesn’t mean it’s going to get solved.