There are two ends of the credit market worth watching: the high yield (junk) market and the "risk free" market (US treasuries). Junk bonds have poor credit ratings and therefore pay out a higher rate of interest to compensate buyers for the increased likelihood of default. US treasuries are often considered risk free because, as the theory goes, the government can simply print more money to cover its interest and principal payments. As a result, treasuries offer lower rates of interest to the investor.
In today's macro environment, where the FED has artificially crammed down interest rates through quantitative easing and other unnatural market policies, yield has become very difficult to come by. Savers and fixed income pensioners have been killed as yields on savings accounts and bond funds are at historically low levels, offering negative real rates of return (depending on who's definition of inflation you subscribe to). As a result, these conservative investors have been forced to "hunt for yield," meaning they must invest in higher-risk debt (ie. junk bonds) just to get a positive return on investment. This hunt for yield has driven the price of junk bond funds to all-time highs.
Zerohedge.com has been ringing the alarm bell for the past two months (most recently here, here, here, and here) on a phenomenon that I'd like to address now. Below is a two-year graph of Barclays High Yield Bond ETF (ticker: JNK). It has been on a relentless 45-degree ascent since bottoming in 2009 as investors bid up high-risk assets in search of any type of yield they can find. In July, this fund saw a fairly dramatic high-volume drop in price, the first of its kind in over 12 months. After a month of declines, price has rallied back just shy of its all-time high, but volume and MACD have been weak - critical non-confirmation indicators that are worth watching.
High-Yield bonds funds saw record outflows of $7.1 billion this week - the fourth week running - as the slow-motion train crash in credit starts to accelerate.
...Simply put - equity prices cannot rally for long without the support of high-yield credit markets - never have, never will - as they are both 'arbitrageable' bets on the same capital structure. There can be a divergence at the end of a cycle as managers get over their skis with leverage and the high yield credit market decides it has had enough risk-taking... but it only ends with equity and credit weakening together. That is the credit cycle... it cycles.
Now I'd like to turn to the other end of the credit market mentioned above: US treasuries. US government debt has always been a safe-haven investment in times of economic duress. Typically during a bull market, you would see investors rotate out of low-yielding treasuries and into equities as stocks would offer higher rates of return through price appreciation and dividend yields. What we've seen these last few years, however, has been an anomaly - thanks entirely to the Fed's quantitative easing program in which it has been buying US debt and mortgage backed debt by the billions each month. So, in addition to seeing continued all-time highs in the broader stock indices, we're also seeing record prices paid for treasury debt. High priced debt means a lower rate of return (as bond yields are inversely related to price). If treasuries are commanding record prices and therefore ultra-low yields, you can see why investors have chased junk bonds higher. They're just looking anywhere and everywhere for some kind of return as anything is better than the negative real interest rates offered by "risk free" debt.
Below is a two year weekly chart of the 10-year treasury note yield (TNX). After bottoming in 2012, yields saw a brief rally into the high 20s (a reading of 25, for example, equates to a 2.5% yield) before moving sideways. Upon closer examination, I would argue that over the past 15 months, we've seen a very nice head-and-shoulders topping pattern as denoted below. Two weeks ago, we saw the neckline violated to the downside with the break of 24. After briefly touching 23, yield rose once again and is now sitting right on top of its 200 dma. RSI and MACD are signaling continued weakness so if yield closes below 23 on a weekly basis, I would expect a swift drop to 18 - the approximate measured move from the head-and-shoulders topping pattern.
The TED spread is an indicator of perceived credit risk in the general economy, since T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. The higher the TED Spread goes, the more perceived risk there is in the economy. Said differently, a rising TED spread often presages a downturn in the U.S. stock market.
The chart below is a five year weekly chart of the TED Spread with the S&P 500 in the lower panel. While not shown here, the spread peaked back in 2008 during the height of the financial crisis at over 4.00. For comparison, you can see that today the spread is all the way down to 0.22 which more or less has been the low over the past 5 years.
Looking at the graph, you can see two spikes in the last five years. Each spike accompanied a sharp decline in the S&P 500 as shown with the green arrows. Even the though the TED Spread measures credit yields, it has a direct correlation with the broader stock indices. For the last two years, the spread has been working its way into a tight wedge with rising support and declining resistance. From a charting perspective, this is a great tradeable consolidation pattern. While you can't necessarily predict the direction of the breakout, you know that when it breaks out (up or down), it will be powerful and likely prolonged.
- Record investor outflows from high-yield (junk) debt as demonstrated by recent weakness in the junk bond ETFs
- 10-year treasury yields beginning to break down within a much large downtrend. This indicates that demand for "risk free" debt is gaining momentum
- The TED Spread is approaching a breakout point. Since it has been consolidating at 5-year lows, the path of least resistance is likely to the upside. Breaking down from here would imply that general market conditions are so strong that LIBOR would essentially equal the "risk free" treasury rate. There is a natural floor of 0.00 for the TED Spread which would imply that LIBOR = the treasury rate (this ignores the possibility of a negative interest rate policy, but that's another discussion altogether).
My takeaway from all of the above is that credit markets are beginning to flash warning signs. We haven't seen complete breakdowns in junk bond prices or treasury yields yet, but the dominoes are set up and the first one is starting to wobble. So, if we see a decisive break below 23 on the TNX accompanied by lower junk bond prices and a TED Spread above 25, then it's time to get out of the stock market. Remember, credit markets lead equity markets so it pays (literally) to keep an eye on things.