From the desk of Steve Strazza @Sstrazza and Ian Culley @Ianculley
It’s no secret.
As investors, we've been rewarded for buying stocks and commodities over bonds for more than a year now. And this will most likely remain the case, as more evidence suggests we’re in an environment that favors risk assets.
The copper/gold ratio hitting new seven-year highs, AUD/JPY testing its year-to-date highs, and cyclical stocks assuming leadership all point to an increasingly risk-on tone.
But for some of us, it’s not as simple as selling bonds and walking away. In some scenarios, we must have exposure to the bond market.
If that’s the case, we want to focus on the riskier areas of the market, just like we’re doing with other asset classes.
Let’s look at a few charts that direct our attention to the strongest areas of the bond market.
First, we have a chart of Inflation-Protected Securities $TIP, High Yield Bonds $HYG, Investment Grade Bonds $LQD, and US Treasury Bonds $IEI:
It would appear that investors are positioning for rising rates and reflation as Treasury Inflation-Protected Securities have been the clear leader this year. TIPS haven’t just outperformed -- they’ve been trending higher while their peers have been heading lower or sideways.
High Yield is currently challenging overhead supply while both Treasury ETFs are rolling over.
We actually like both TIP and HYG here as vehicles to position ourselves in the bond market.
Our thesis on global growth, reflation, and higher rates should explain why we like TIPS so much, but what about high yield? Let’s dive in a bit.
Not only do high-yield bonds tend to hold up well in a rising rate environment, but they also have a strong historical correlation with small-cap stocks.
Here's the 63-day correlation between HYG and the Russell 2000 ETF $IWM:
The correlation has been consistently positive looking back about a decade.
Bonds normally have a negative correlation with stocks, so this is probably going to surprise some people.
The message here is that higher prices in HYG have more to do with investors seeking risk than with what's happening to treasury yields. In fact, HYG has a consistently negative correlation with Treasuries. So, if we think treasuries are headed lower (which we do) high-yield bonds could very well be headed higher from here.
The bottom line is if rates are on the rise and investors are beginning to reach for risk, high-yield corporate bonds are most likely producing the alpha in the bond market.
That’s where we’re focusing our attention now.
Here’s a daily chart of HYG:
The trade is simple, as risk is well defined at the former 2017 highs around 89. We want to buy on strength above those former highs with an upside objective of 102.30.
But the long side of HYG is only valid above 89, so our bias remains neutral until we see a decisive breakout.
The bond market has spoken.
Rates are on the rise across the curve, and risk assets that benefit from rising rates are moving in accordance -- think copper, crude oil, regional banks, and explorers and producers.
This does not bode well for US Treasuries or other defensive assets.
If we have to be long bonds, we should choose the vehicle best suited for the current environment: high-yield corporate bonds.
