Risk On or Risk Off? [Weight of Evidence, Part 4 of 7]

Weight of Evidence: Part 1 | Part 2 | Part 3 | Part 4 | Part 5 | Part 6 | Part 7

The credit (aka bond) markets overshadow the equity markets in terms of dollar value. Yes, the equity markets get all the publicity and headlines. However, it is the waters of the credit market that run deep. By looking at the current state of the credit markets, we can learn about the relative health of a large portion of the financial industry. When the bond markets speak, we listen.

At 360 Investment Research, we examine investor demand for various grades of credit (Junk Bonds, High Yield Bonds, and Treasuries). Specifically, we compare these grades against each other as a ratio. See the first chart below. This is a ratio of High Yield Bonds versus Treasuries, represented here by ETFs HYG (High Yield) and TLT (Treasuries) in blue. This ratio tells us the credit market’s appetite for risk. When in a speculative mood, funds will flow out of Treasuries (less risk for lower yield) and into High Yield Bonds (more risk for higher yield). When more risk is being taken, the ratio rises. The opposite also applies. When the bond market is seeking safety, it flies to Treasuries and the ratio decreases. This is what we find right now – the ratio has been declining – the credit market has been seeking safety since January. All the while, stocks (the more speculative market) have been rising. The credit market is seeking safety while the stock market seeks more risk. This is unusual behavior. Normally, they are in agreement. When big money managers are increasing positions of risk within the stock market, the same takes place in the bond market with funds flowing into High Yield credit. So the fact that we have this divergence is a problem. Who’s right? I don’t know, but it will resolve itself one way or another. Either stocks are going to correct downward or the credit market is going to flow into High Yield.

Even though we don’t know what will happen this time around, when we look at the past, the credit market seems to be right more often than not. That leads us to our second chart, which shows proprietary moving averages of the same type of ratio comparing High Yield Bonds v. Treasuries (JNK:TLT). This is placed in the same chart as the S&P 500. Not only do we notice that when the moving averages cross (green below orange), it’s a good time to sell stocks. We also notice that these ratio moving averages can give early warning signs through divergence. More often than not, the credit market flees to Treasuries before equities sell off. In 2011, the bond market diverged from stocks for more than six months before there was some type of resolution (stocks sold off). We find ourselves in the same spot now. The bond and stock markets have diverged from each other for the past 11 months. Who’s right? We don’t know, but we’re going to find out sooner or later. Either stocks sell off or the bond market seeks High Yield. Get your popcorn ready.

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Weight of Evidence: Part 1 | Part 2 | Part 3 | Part 4 | Part 5 | Part 6 | Part 7