Bonds Begin to Buckle

From the Desk of Ian Culley @Ianculley

Don’t let credit spreads fool you. 

High-yield debt hasn’t blown out relative to Treasuries. Regardless, the largest markets in the world are buckling under pressure.

You have to look outside the US and beyond high-yield corporate bonds to see the stress. Here are three cautionary data points to consider: European sovereign spreads, US bond market volatility, and the steep decline in investment-grade bonds.

When you weigh the evidence, it’s clear risks are rising for US markets. 

Let’s look at the charts!

First, here's a look at European sovereign spreads:

At first glance, these spreads look similar to high-yield spreads. They’re chopping sideways at or near their peaks from the 2020 crash. Nothing alarming or unusual from the countries at the highest risk of default – Spain, Italy, or Portugal. 

It’s a different story when it comes to the UK, as the spread between the UK-German 10y yields blew out this week to 225bps:

A 200-basis-point spread with the German benchmark rate seems elevated (yet reasonable) for Italy or Spain. But it’s almost unthinkable for the UK. These are levels not seen since the early 1990s.

European sovereign spreads are beginning to widen at alarming rates. It’s starting with a pillar of financial stability, the UK, raising concerns of comparable volatility spreading across developed markets.

Though the US has yet to experience volatility on a similar scale, it remains elevated and rising. The bond market volatility index $MOVE has now reached levels last seen during the pandemic sell-off.

The last time bonds were this unhinged, the Fed threw a historic QE package at the market. Today, they’re tightening at the fastest rate in four decades.

How this plays out is anyone’s guess... 

What’s clear is the bond market has reached unsustainable levels of volatility that coincide with past crises. It’s evident across the market.

Check out the decline in the Investment Grade Bond ETF $LQD this year:

This fund represents the highest quality corporate debt there is. LQD is down more than 22% during the trailing twelve months, undercutting its pandemic lows. If this doesn't signal distress, what does?

Credit markets are clearly under increased pressure. Some of the world’s most reliable sovereign spreads are widening, bond market volatility is through the roof, and investment-grade bonds are in free-fall.

The environment is deteriorating as risks intensify. Don’t try to pick the bottom. Instead, focus on risk management and protecting capital. 

It all comes down to listening to the bond market. Right now, it’s telling us risks are on the rise. Act accordingly.

Following the Fed's 75-basis-point increase last week, the market is pricing in a double-hike in November.

Here are the target rate probabilities based on fed funds futures:

Click the table to enlarge the view.

This data is from the CME FedWatch Tool as of September 29, 2022.

Thanks for reading. And please let us know what you think.

As always, be sure to download this week’s Bond Report!