From the desk of Steven Strazza @Sstrazza and Ian Culley @IanCulley
The Federal Reserve is doing its best to prepare the market for what is expected to be a year of rate hikes. But investors aren’t exactly enthusiastic about this outlook, as stocks came under further pressure following Wednesday’s Federal Open Market Committee announcement.
The bond market is also offering some valuable information again. And considering the recent volatility, it’s more important than ever to listen closely.
When we think about bonds, credit spreads are always top of mind, as they’re a great barometer of market health. When there's stress on risk assets, it shows up in credit spreads.
When analyzing credit spreads, all we’re doing is measuring the difference in yield between a Treasury (the safest bet) and a corporate bond (riskier asset) of the same maturity. If these spreads begin to widen, it’s usually problematic for equities.
We can also study these relationships by comparing the bond prices themselves, instead of their yields. One of our favorite ways to do this is by charting the High-Yield Bond ETF $HYG relative to the Treasury Bond ETF $IEI.
We’ll dive into this ratio in today’s post and discuss where it’s likely headed from here, and more importantly, what it all means for risk assets.
First up, we have a chart of the HYG/IEI ratio overlaid with the S&P 500 $SPY:
When HYG/IEI is trending lower, it means credit spreads are moving higher, or widening. Remember, yields are simply a function of bond prices.
When we look at these two charts together, it’s clear that they tend to top and bottom around the same time. This makes sense. When times are good and investors are embracing risk, stocks tend to rally and high-yield bonds tend to outperform.
Now, let’s talk about what’s happening today. HYG/IEI has built a topping formation and is beginning to turn lower as credit spreads widen. This is not a good look for equities.
The HYG/IEI ratio is largely driven by the rate of change in the numerator, which is high-yield bonds. This is simply because it's the higher-beta component.
To illustrate this point, here's an overlay chart of HYG and the HYG/IEI ratio:
As you can see, the ratio essentially follows high-yield bonds on an absolute basis.
For this reason, it’s important we pay close attention to the corporate bond side of the relationship.
Here we have a chart of HYG on an absolute basis:
After nearing an area of significant overhead supply, HYG is completing a 12-month rounding top and making new lows.
Given how closely HYG and HYG/IEI move together we have to ask the question…
Will a breakdown in high yield bonds lead to widening credit spreads?
It’s not just possible -- it’s likely. But this is only the case if we get a downside resolution in high-yield bonds.
In this environment, even if treasuries break down simultaneously, HYG is likely to outpace US treasuries to the downside. This means lower prices for the HYG/IEI ratio. Historically, this has meant problems for risk assets.
The bottom line is bulls want to see high-yield bonds recover ASAP. If they don’t, then we have to expect lower prices for high-yield will lead to widening credit spreads. And this is definitely not something the bulls want to see.
It hasn’t happened yet. But with HYG at fresh 52-week lows, the writing is on the wall. With rates on the rise and the US stock market under pressure, it’s time to watch these developments closely and heed the message of the bond market.
Stay tuned!
Countdown to FOMC
Based on the most recent Federal Open Market Committee meeting, the market is pricing in a rate hike in March 2022.
Here are the target rate probabilities based on fed funds futures:
This data is from the CME FedWatch Tool as of January 26, 2021.
Thanks for reading. As always, let us know what you think.
And be sure to download this week’s Bond Report!
