Tail risk, or black swans, refers to low probability events that have huge negative outcomes. Looking over the history of equity and bond markets since the early 1990s we observe a secular decline in Treasury yields and corresponding rise in equity prices. It is interrupted, however, by two sharp upward spikes in investment grade BAA corporate spreads (difference in yield between corporate bonds and Treasuries) and downward spikes in Treasury yields as well as equity prices – corresponding to the collapse of the tech and housing bubbles. While speculative excess has been a hallmark of capitalism since its inception, it is the much more recent history of the Fed’s role in shoring up weak markets with ever larger liquidity injections starting in 1987 that has created the conditions, including high debt levels, for successively bigger speculative bubbles and potential black swans. (See our archived feature – Irrational Exuberance).
Look for sharp increases in corporate spreads going forward to signal new turmoil in equity markets which in the absence of a tail wind from further secular declines in Treasury yields will not be offset by a rising tide of equity prices.
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