Pay Attention to Bond People
Igor Manukhov - Aug 11, 2023
Risk spreads continue to shrink. A good sign for stocks.
Markets continue to absorb the impressive rally we enjoyed over the last few months. Naturally, people question whether this is the end of a good time or just a pause for breath. So far the weight of evidence suggest that this is merely a pause in the ongoing bull market. One of the secondary indicators that I use is the high yield over investment grade spread. This metric dictates how much extra return the market is demanding for lower quality bonds (aka high yield, or junk bonds) in addition to the rate offered on high quality bonds (usually treasuries). When markets are bad this spread tends to expand, suggesting that people get more nervous and demand higher premiums to invest into low quality risk assets. Falling spreads tend to be good for risky assets like stocks.
This is an important metric to track because bond investors tend to be more risk averse than stock investors. They tend to be more sensitive to any increase in risk, and are more diligent about changing market conditions.
On the chart below, the black line represents this high yield spread, while the red line represents the US stock market. Check out the pink circles to see what happens to stocks when spreads are rising and what happens when spreads are falling. At the moment spreads continue to fall, so I would treat this pullback as a buying opportunity until proven otherwise. Pay attention to the bond crowd.
