Mish points out accurately that corporate bond yield spreads from Treasury yields are a good indicator where stocks are headed:
Keep an Eye on Bonds!
As long as corporate bonds fetch a good bid, which in turn allows companies to raise cash at decreasing costs, the stock market is likely to be reasonably firm. Note that the pullback in junk bonds began 3 days ago on that last red candle.
I am skeptical the rally in bonds can last much longer, but until the corporate bond market starts showing increased signs of stress, equity bears expecting huge pullbacks are likely to be disappointed.
Either way, it will pay to keep one eye on the credit markets to help ascertain long-term equity direction. In August of 2007 the corporate bond market cracked wide open. Although the S&P 500 made a new high in November, the corporate bond market didn’t. It was the mother of all warning calls that most missed.
I prepared a chart that compares Treasury note prices (IEF, blue), corporate bond prices (HYG, red), and the S&P 500 (green), since October 2007:
Click on image to enlarge.
The question is where are corporate yields headed and where are Treasury yields headed. So long as the spreads remain flat or continue to narrow, stocks will probably move sideways or spike up a little more. But as we can see in the chart above, it looks like they are very slowly beginning to widen again. It’s too early though to identify a clear direction at the moment.
News like this certainly won’t bode well for the bond market and will continue to apply downward pressure to corporate bonds, and thus upward pressure on spreads:
The number of U.S. companies that have defaulted on their debt this year rose to 12.2% in August, matching a peak last touched in 1991, Moody’s Investors Service said in a report Wednesday. The default rate is expected to rise to 13.2% in the fourth quarter, then drop to 4.1% a year from now, analysts said. A key part of that forecast is that U.S. unemployment will peak at 10% in 2010, said Moody’s Kenneth Emery. On Friday, the Labor Department said the jobless rate reached 9.7% in August. “If the U.S. unemployment rate were to increase substantially above 10% in the coming year, then default rates would likely be significantly higher than indicated under the model’s baseline scenario,” Emery said.
Here is a nice straight resistance line that corporate bonds are testing right now:
HYG Chart:
The downward trend since October 2007 continues to hold up.
Meanwhile, the exact opposite holds true for Treasurys:
IEF Chart:
… bottom line: keep an eye on corporate vs. Treasury yields.