Last week we discussed the complacency financial markets have been taking with respect to a first Federal Reserve interest rate increase and as a result markets were vulnerable to surprises both for the bond market and equity markets.
In summary, as economic data and Fed rhetoric increased the risk of an earlier rate hike in September or October, financial markets would have to adjust very quickly. Selling in bonds and equities would result. But in a case of “buy the rumor and sell the fact”, once the first rate hike was out of the way markets would rally aggressively because one 25 basis point increase would do little to negatively impact the economy and the next rate hike would be 6 months away.
This past week we have seen a rapid sell off in bonds across the globe, with bond yields spiking and equity markets have become more noticeably volatile. The move in bond yields should not be ignored because it has started to affect the entire spectrum of debt, from government through to corporate including both junk and investment grade.
Firstly below I show the move in US 10-year bond yields that spiked to 2.4% this week and are starting a new trend higher. A large base formation in yield is being completed and while the trend may be slow it is nonetheless moving higher.
The greater concern for equity investors is the movement in corporate debt. Over recent years with central bank policy keeping interest rates so low investors looking for yield have been forced to take on greater risk by investing in lower grade debt. This has had the effect of driving down yields even on the highest risk debt to levels that in “normal” times would be considered ludicrous. Our concern is not the absolute level of these yields but the change in direction and the speed at which they occur. The best way for those playing at home to keep track of these corporate bonds is through Exchange Traded Fund listing in the US.
The iShares High Yield Corporate Bond ETF (Code: HYG.ARC) is listed on the US ARCA exchange and tracks an array of low investment grade corporate bonds. As prices fall the yield rises and it can be seen that since mid-June 2014 there has been a general downward drift in price. A lower price means investors need a degree of compensation (that is yield) to warrant an investment.
Now the decline between June and December 2014 is largely the result of the oil price collapsing. Many oil producers became a high risk of defaulting on their debt due to a rapid decline in lost revenues. But outside this period movements to the downside are always concerns for equities. If bond investors are worried about corporates defaulting and thus selling their bonds, equity investors should also be concerned – especially when they rank behind debt holders in the case of liquidation.
As a result declines in the HYG ETF precede declines in the S&P 500. Below I show the HYG index overlaid with the S&P500. It can be seen that the HYG often begins to fall before the S&P 500 – which can even make new highs – before eventually catching up to the HYG fall. If you ever want to know when equity markets are running into a red zone of heightened risk of a correction watch this chart.
There has been a sharp sell-off in the HYG index in the past week and aside from the drop on Thursday night in the S&P 500, equities have again been defiant. This defiance can continue but if corporate bonds continue to sell off, it only increases the risks of a negative reversal in the S&P 500.
Now I have to stress, this doesn’t immediately mean a sudden return to the GFC panic and the S&P 500 is due for a crash. Hardly. I live in the real world having to make real profits from real trades. In essence I have to keep it real. So “Marc Faber” market calls of imminent market crashes of 50% hold no relevance or use. 99.999% of the time they are wrong. I like to look at where risks are increasing of a correction and then adjust accordingly. Every market crash needs to correct 5% first before it can fall any further. Plan for a 5% correction or 10% and reassess at that point.
As we discussed last week and evidence cemented this week by bond and equity markets (especially the ASX 200!), this is a time to start reassessing the risk profile of your portfolio and your positions. Market surprises tend to occur when investors are most complacent and warnings signs are emerging that we should all be aware of.
