From the desk of Steven Strazza @Sstrazza and Ian Culley @Ianculley
When it comes to the bond market, credit spreads are always top of mind. They provide critical information regarding the liquidity and stress of the largest markets in the world.
While most of us aren’t full-time bond traders, in many cases we turn to these assets to offset the risk associated with the equity side of our portfolios. That’s fine.
But when credit markets come under stress, it affects all asset classes, especially equities. We’re seeing this now.
Earlier in the month, we noted that these crucial spreads were widening to their highest level since late 2020 as the high-yield bond versus Treasury ratio $HYG/$IEI hit new 52-week lows.
It’s no coincidence that the major stock market averages fell to their lowest level in over a year as this was happening.
This is why we pay close attention to credit spreads. They give us information about the health of other risk assets.
Right now, with HYG catching higher on both absolute and relative terms, they’re telling us we could be in for a relief rally.
Let’s hone in on the recent action in high-yield debt and discuss what this means for stocks in the near term.
Here’s a chart of the High-Yield Corporate Bond ETF HYG with a five-day rate of change in the lower pane:
We like to focus on the riskier side of the HYG/IEI ratio, as it tends to drive the relationship. In the past couple days, it’s driven it much higher as HYG has experienced a major rally.
Yesterday, HYG clocked its largest single-day rate of change in more than two years. That constitutes a tactical momentum thrust.
This type of action tends to lead price. We’re also seeing thrusts on longer time frames.
The chart above illustrates just how useful these simple momentum readings have been in the past. The five-day rate of change just hit similar levels that coincided with significant bottoms in 2016 and 2018.
There was also a very extreme reading at the COVID-crash low in 2020.
Notice the price reversals that HYG experienced following these momentum thrusts in the past. We’re anticipating similar follow-through in the coming weeks and months.
This is extremely bullish and adds to our conviction that HYG has carved out a near-term bottom. But this tells us more than that.
If a sustained rally in high-yield bonds takes hold, that would likely cap credit spreads, relieve the stress on bonds, and support a rally in other risk assets, particularly equities.
On the flip side, if HYG ignores this signal and rolls over, credit spreads are most likely widening, and stocks are kicking off their next leg lower.
While this is certainly a possibility, for now we want to give HYG the benefit of the doubt and see how far this counter-trend move takes us… and, more importantly, how it impacts spreads.
This adds to the growing list of potential intermarket developments supporting a relief rally in stocks – US dollar weakness, tradeable lows in bonds, and now tightening credit spreads.
As things currently stand, they’re heading in a direction that favors stocks.
The bottom line is the environment is improving for risk over the very short term.
Whether or not this turns into a real trend is yet to be seen.
Countdown to FOMC
Following the Federal Reserve’s recent rate hike, the market is pricing in a 50-basis-point hike at the June meeting.
Here are the target rate probabilities based on fed funds futures: *Click table to enlarge view
This data is from the CME FedWatch Tool as of May 26, 2022.
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