The Bond Market Reaches for Risk

From the desk of Steve Strazza @Sstrazza and Ian Culley @Ianculley

We’re beginning to see signs that risk-on behavior is re-entering the market.

Commodities are ripping in the face of a rising dollar.

Cyclical stocks are back in gear as the S&P 500 High Beta ETF $SPHB posts higher highs and higher lows relative to its low-volatility alternative $SPLV.

Meanwhile, classic risk-appetite barometer AUD/JPY sliced through a critical level of former support-turned-resistance earlier this week.

All of these point to an increasing risk-on environment. 

But what does the bond market have to say about investor positioning toward risk?

Let’s look at a couple credit spreads that speak to investors’ willingness to incur risk.

First, we have the Investment Grade Corporate Bond ETF $LQD relative to the US Treasury Bond ETF $IEF:

Investment-grade corporate bonds showing strength relative to US treasuries is a clear sign of a risk-on environment. If investors are willing to pass on a practically risk-free US Treasury bond to gain a few basis points, they’re most likely confident that the US stock market isn’t falling apart. They’re probably instead betting that stocks are headed higher.

It’s important to note this ratio has been stuck beneath overhead supply for the last decade, repeatedly testing an area of long-term resistance.

But the challenges to the resistance level have become more frequent. As the old saying goes -- the more times a level is tested, the higher the likelihood it breaks. 

A sustained break above the key level of ~1.16 signals risk-seeking behavior is entering the market, and that investors are positioning themselves for the next leg higher in risk assets.

Let’s move on to the riskier High Yield Corporate Bond ETF $HYG vs. the US Treasury Bond ETF $IEI: 

High-yield bonds outperforming their safer alternative is yet another development that points to market participants’ clear choice to take on risk.

High-yield bonds are the riskiest of the risky. They’re often referred to as junk since they are far more likely to turn out to be total garbage.

It’s promising to see the HYG/IEI ratio challenge an area of former support-turned-resistance again and again. 

If investors are seeking returns from junk bonds, the message is simple -- the beta chase is on! 

To be clear, we’re not there yet.

Both ratios are still stuck below their respective resistance levels and we’re still seeing plenty of mixed signals across the market.

SMIDS remain range-bound, Copper chops sideways, and the USD continues to push toward new 52-week highs.

But there are signs that the market environment is beginning to shift toward a more risk-on tone.

We’ll continue to keep a close eye on the HYG/IEI and LQD/IEF ratios for confirmation from the bond market.

Thanks for reading. As always, let us know if you have any questions or comments. 

And be sure to download this week’s Bond Report below!