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December 3, 2007

Jim Hamilton: Where's the Risk?

Jim Hamilton can't find much evidence that recent financial turmoil signifies fear of an economic downturn:

Where's the risk?, by Jim Hamilton: Usually an economic downturn is associated in a big increase in the spread between corporate and Treasury yields. This spiked pretty dramatically last week, but still has a long way to go.

Difference in yield between Moody's Baa-rated corporate debt and constant-maturity 10-year Treasuries based on monthly averages, with NBER recessions indicated as shaded regions. Data sources: FRED [1], [2].

The above graph plots monthly averages of the corporate-Treasury yield spread through July. Going back to 1953, this spread averaged 170 basis points, and typically rose over a hundred basis points during an economic downturn. Insofar as there is a higher probability of default during an economic recession, even risk-neutral investors would require a higher yield on corporate debt when more businesses are failing.

This spread spiked substantially last week, as long-term Treasuries fell 20 basis points while the Baa yield showed little movement. Even so, the current spread of 206 basis points is not much above the long-term average or the short-term range we've seen over the last two years.

Daily values for difference in yield between Moody's Baa-rated corporate debt and constant-maturity 10-year Treasuries. Data sources: FRED [1], [2]H.15. and FRB release

If the financial turmoil over the last few weeks reflects fears of a significant economic downturn and financial distress, I would have expected to see an even bigger spread at this point.

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