Signs of Stress in the US Bond Markets

We’re starting to see some real signs of stress in the US bond markets.

Perhaps this is just some short term repositioning in case the US Federal Reserve actually follows through with its threats to lower the size of QE purchases.

Or insiders have been given word that it’s going to happen and they’re front running the crowd.

But one thing is certain. The US bond market and the spreads between US bonds and underlying corporate bonds are starting to widen. Volumes have exploded and there are some big moves…

On 16 May (the day after the high) I included this chart showing you my prediction for the ASX 200:

Click to enlarge

I said at the time that ‘The first thing I need to see is a close under the 15th March high of 5,163. From there we should see a retest of 5,025-5,040. If the market can’t hold above that level then we’ll be re-entering the major long term range and we could expect to see a pretty quick trip to 4,700.

Three weeks later and the market is trading at 4842, down 7%.

Now it’s the US stock market’s turn. As I wrote in last Friday’s weekly update to Slipstream Trader members:

If we were to see a weak night in the States tonight with a close under last week’s low of 1635 that would create a weekly sell pivot and could signal more downside next week.

But to understand why US stocks could fall further, you need to look at the US corporate bond market and the spreads between corporate bonds and government bonds.

The chart below is the iShares High Yield Corporate Bond ETF [NYSE: HYG].

HYG Weekly Chart

Click to enlarge

It’s quite clear from the above chart that we have seen an amazing rally in junk bonds since the lows in 2009.

In the last five weeks we have seen a sharp sell-off in HYG with a fall from a high of $96.30 to a low of $91.80. That’s a 4.6% fall. Volume has increased steadily, with the volume traded on 3 June of 14.3 million the highest volume since inception of the ETF in 2007.

In other words some big players are heading for the exits.

Have another look at the chart and you can see the horizontal blue line that corresponds to the high from mid-2011. I would see a failure below that level as a false break of the high on a monthly chart. The huge increase in volume of late increases my conviction that you could see further big falls from here.

The fact is the spread of junk bonds over Treasuries is now an absolute joke. I think it’s one of the pressure points within the financial market that has the US Federal Reserve quaking in its boots as it dawns on them that they’ve created a monster.

Junk bonds will traditionally trade at up to 10% over US Treasuries due to the high risk of default. Lately junk bonds have been trading under a 5% total yield! The lowest on record.

This at a time when half of Europe is in a depression, Chinese manufacturing is barely growing and the US is not far away from stall speed.

An article on states that:

The trailing 12-month default rate on U.S. high-yield debt is very low – 1.8 percent as of April, according to Fitch Ratings, “extending a three-year run” of being well below the historical annual average of 4.6 percent.

Institutional “covenant-lite” loan volume was near $80 billion in the first quarter, according to Moody’s Investors Service. That’s equal to the total for all of 2012. Covenant-lite debt comes with fewer or no restrictions on things like collateral, payment terms and earnings performance. Similarly, high-yield bond issuance is up 16 percent in 2013.

Of course it should be pretty obvious that the risk of losses increases dramatically with the lessening of covenants. We’ve seen this play out before in 2000-2001 and in 2007 when a surge in asset values due to easy Fed money fostered a low default rate environment.

According to the Fitch report cited in the article above, ‘The low default rate perpetuated the cycle of aggressive transactions and was in the end a red flag of systemic risk rising rather than shrinking.

An article in the Wall Street Journal on 8 May pointed out that ‘the default rate on junk bonds is ticking up. It was 3.1% in the U.S. in April, from 3% at the end of April last year, according to Moody’s Investors Service. The default rate hit 14.6% in November 2009, Moody’s said.

So how can investors play a market such as the high yield corporate bond market in the US?  Well it sounds daunting but it’s actually fairly easy. Once you have set up an account with a broker enabling you to trade US stocks you could buy an ETF such as the ProShares ‘short high yield’ ETF with a code of SJB.

SJB Short High Yield ETF

Click to enlarge

This ETF goes up in price as the high yield bond market goes down in price. You can see from the chart that the price has fallen steadily for the past year but has turned a corner in the last month with prices rising from around USD$30.22 to USD$31.40 on big volume. If some real cracks start appearing in the credit markets then this ETF should skyrocket.

Where Bonds Go Stocks Follow

The stock market should be eyeing off what’s happening in the bond market closely. Where the bond market goes stocks will follow.

One measure to watch is the high yield spread over Treasuries versus the S+P 500. While investors are embracing risk the spread will fall and stocks will rise.

Source: Seeking Alpha

The high yield spread is inverted in the chart above so you can see the relationship between a falling spread and a rising stock market.

As you saw above the high yield spread is now rising sharply but the stock market is still flirting with the all-time highs. Something has to give.

Either the high yield bonds will have to start rallying again or the US stock market is on the edge of a big sell-off.

Even Investment Grade (IG) credit spreads are starting to widen. 

As noted on ZeroHedge after the large move in IG credit spreads on Tuesday ‘this is the biggest range in IG credit since Nov 2011. The last time we were at these levels was early 2011 and the rise in range then signaled the start of an extreme correction (from 80bps to over 150bps).

So the warning bells are clanging loud and clear at the moment that a correction in US stocks is in the wings. Last night’s 1.4% move could be just the beginning.

Murray Dawes
Editor, Slipstream Trader

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Murray Dawes is the Editor of Pivot Trader and contributing Editor at Money Morning. He was one of five, from 5,000 applicants, chosen for a graduate position with the Swiss Banking Corporation — now part of banking giant UBS. The bosses quickly cottoned on to his potential and pushed him up the ranks as a futures broker on the floors of the Sydney Futures Exchange. Murray later broke out on his own and developed custom trading systems to trade leveraged financial instruments like futures. Due to his success, Murray became the ‘hired gun’ trader for Australia’s rich and famous. Today, Murray runs a trading service through Fat Tail Investment Research to help everyday Aussie investors use his advanced trading methods.

Money Morning Australia