Stress in Financial Markets

Most people see headlines about how the stock market is performing (worst month since 1987; one of the worst days since 1931; best percent gain since 1933, ...).  But understanding the bond market requires more thought.  One can hear about yields (interest rates) on government bonds being at historic lows, but why are some mortgage rates higher than before the crisis?  Believe it or not, the US government is considered to be extremely low risk while everyone else is perceived to be riskier and thus bond investor require additional interest to compensate for taking on that risk (e.g., J.C. Penney's needs to pay a higher interest to get you to buy its bond to compensate for the risk you're taking that they may not pay it back).  AAA-rated companies are the safest (and rarest), Baa are normally safe ("investment grade") and then there are junk bonds (or high-yield bonds).  So what's been going on in the bond market recently?  Here's a chart of the yield on the average AAA bond compared to US Treasury bonds:

Notice that spike at the end?  Compare it to the financial crisis of 2007-2009...  As of Friday, Mar 20, the spread between the yield on AAA-rated bond compared to Treasury bonds hit 3.2% (exceeding the peak of the financial crisis, 3%).  Fortunately, the Fed's actions have brought it down this week (2.8% on Monday, the latest data available as of now).  What does this mean?  If the safest corporations have to pay more for access to credit, what about those who are safe, but not AAA?  This would have a devastating effect on the economy.  The Fed's massive intervention has reduced some of the systemic risk in the economy.  This is also a reason that the government is about to approve loan guarantees as part of the stimulus package (support access to credit).

In the coming days, I'll be watching how risk premiums (difference between the interest rate one has to pay relative to the safest borrower, the US government) are behaving.  The hope is that they will be declining this week, but remaining high (just not quite as high).  It's going to take some time to make it through this, but we want to minimize the damage along the way.