Junk Bonds and Fed Stress Index Portend Worsening Stock Markets

 |  Includes: CIU, HYG, IVV, JNK, LQD, SPY
by: Richard Shaw

We expect stocks to decline more before they change direction.

The macro factors in the U.S., Europe and China suggest that. The stock charts suggest that. The high price and low yields of intermediate-term and long-term Treasuries suggest that. And, so do the yield spreads between investment grade corporate bonds and below investment grade bonds.

This chart shows low quality to high quality corporate bond yield spread, based on the Bank of America / Merrill Lynch BB and AA indexes.

A key observation is that the current spread at 468 basis points as of October 6th is higher than it was at any time since September 11, 2009, and then not before October 7, 2008 until we get back to March 28, 2003.

The rise in the spread shows a deterioration of the view of relative credit worthiness, which is a view of the direction of the economy. In a declining economy, the weaker companies have a harder time servicing debt and have a higher risk of default. That makes their bond prices fall and the yields rise.

This spread tends to be coincident or slightly leading of the stock market direction, as shown in this chart of the spread versus the S&P 500 (each indexed to its beginning value).

The spread began to build after the 1997 Asian currency crisis presaging the 1998 Russian currency crisis and the Long-Term Capital debacle. It then subsided, and began to rise again before the 2000 dot-com crash.

The spike in 2001 corresponds to the 911 terrorist attack on the US, and the US invasion of Afghanistan as a result of the 911 terrorist attack.

The spread peaked with the 2002-2003 stock market bottom, and declined as stocks rose through 2007. It then began to rise prior to the 2008 stock market crash. It peaked a couple of months before the 2009 stock market bottom, and then declined as stocks rose.

It began to rise in May of 2011 approximately coincident with the late April high for stocks.

The correlation is not perfect, but it is potentially helpful as one of several indicators you might consider when seeking evidence of confirmation or divergence with stock moves.

If the yield spread is not rising and stocks are declining, that is one point of evidence that the stock decline is perhaps not about to be a major move.
If the yield spread is rising and stocks are falling, that provides some confirmation from the bond world that the situation is deteriorating.

In the current situation, the rising yield spread is a function of junk bonds falling in price (yields rising), and not so much due to changes in investment grade bond prices. That is a more mixed picture than if all bond prices were making significant moves and the junk bonds were falling more than the investment grade bonds.

This chart shows the yields of BB and AA corporate bonds separately.

One might conclude that high yield bonds are a good opportunity, because they may be overreacting to circumstances. Alternatively, on might conclude the investment grade bonds are a poor opportunity, because they have not yet faced up to the deteriorating economy. Bond investors have to decide if the glass is half full or half empty.

An adjunct indicator is the St. Louis Federal Reserve's "Financial Stress Index". It is rising and signaling a worsening situation.

This index evaluates 18 short-term and long-term bond and bond related criteria to determine how much stress is in the US financial system.

The current stress level is higher than it was at the worst time in 2010, and at 1.080 is higher than it has been since September 4 2009. The stress level did not reach or exceed the 1.08 level until March 3rd, 2008 by which time things were pretty dicey for stocks.

The yield spread between junk bonds and high quality bonds is not diagnostic, but it is one of several pointers that should be considered.

They are flashing yellow warning lights at a minimum.

See other articles by us with direct analysis of S&P 500 charts indicating a bear is at hand:

Related Recent Articles:

Representative Securities:

  • investment grade corporate bonds: CIU, LQD
  • below investment grade corporate bonds: HYG, JNK
  • S&P 500: SPY, IVV

Disclosure: QVM has a short position in SPY and wrote near-term, far-out-of-the-money PUTs on SPY; and does not have positions in any other mentioned security as of the creation date of this article (October 7, 2011).

Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.