From the desk of Steven Strazza @Sstrazza and Ian Culley @IanCulley
Not all stressors are debilitating.
In some cases, stress can push us to perform at our highest level. But, of course, there are instances when opposing forces become overwhelming, making it near impossible to reach our goals.
We’ve all been there.
And the markets are no different.
While we keep tabs on our heart rate or blood pressure to gauge our stress levels, we focus on credit spreads to measure stress in the market.
Given that rates continue to rise worldwide, it’s an appropriate time to evaluate these spreads and the potential obstacles that may lay ahead for risk assets.
We recently broke down credit spreads in anticipation of them widening and outlined some charts that are driving this trend.
Read our January 27 post for more information about the ins and outs of credit spreads and how we analyze them.
Since these spreads provide valuable information on the health of the overall market, we’re going to check back in and discuss another chart that is on our radar.
Let’s dive in!
Last month, we made the argument that junk bonds need to find their footing or else spreads were likely to keep moving higher. In the few weeks since, they have continued to fall, and spreads have continued to widen.
Let’s take a look at some of the “junkiest” bonds now to get a feel for what’s happening in the high-yield space.
Here’s a chart of the Fallen Angel High-Yield Bond ETF $ANGL:
This ETF mirrors the ICE Fallen Angel High-Yield Index, which is comprised of corporate debt that was recently downgraded to junk status.
Long story short, these are the newest high-yield bonds on the street, and they carry a lot of risk.
We’re keeping a close eye on ANGL for the same reason we’re watching the High Yield ETF $HYG right now — a sustained breakdown in high yield debt will most likely lead to higher credit spreads.
As you can see in the chart, ANGL is testing a key level of former resistance turned support around 30.55. The ETF has been under relentless selling pressure for the past two months, but it is now at a logical level to dig in and find a bottom.
If it can carve out a tradeable low, we’re likely to see a near-term peak in credit spreads.
On the other hand, if it slips below those former highs, we’re likely in an environment where junk bonds are outpacing treasuries to the downside, which would be evidence of stress in credit markets.
To be clear, we’re not seeing signs of significant stress yet. But with both spreads and high-yield bonds near critical levels, this could change any day now.
Here’s a chart of the S&P 500 ETF $SPY overlaid with the High-Yield Bonds versus Treasuries ratio (HYG/IEI) — which is just another way to visualize what’s happening with credit spreads:
The HYG/IEI ratio is forming a distribution pattern as it tests a key level of former support for the fourth time over the trailing 52 weeks.
If and when the ratio rolls over, it means high-yield debt is falling at a faster rate than treasuries… and, as a result, credit spreads are widening.
In that environment, high-yield bond ETFs — like ANGL and HYG — are probably breaking down and resolving lower.
More importantly, major stock market indexes like the S&P 500 are likely following to the downside.
The bottom line is bulls want to see high-yield debt dig in at current levels and rebound to the upside.
If they fail to do so, then we have to expect that falling high yield bonds will lead to widening credit spreads and increased market risk. That’s the last thing bulls want to see.
Again, it hasn’t happened yet. But markets are vulnerable with credit spreads and junk bonds trading at such critical levels.
By focusing on high-yield debt we gain insight into the health of the market and the potential hurdles for the next leg higher in equities.
This is one of the more important developments of late, so we’ll be sure to follow up when we get more information.
Countdown to FOMC
Following the most recent Federal Open Market Committee meeting (and the release of the meeting minutes this week), the market is pricing in a rate hike in March 2022.
Here are the target rate probabilities based on fed funds futures:
Thanks for reading. As always, let us know what you think.
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