If stocks are about to come under real pressure, you’re going to see it in credit.
That’s how markets work.
The bond market is much larger than the stock market. When the world’s biggest institutions start to feel stress, when there are real structural problems beneath the surface, that stress doesn’t stay hidden.
It shows up in credit.
That’s why equity investors should always keep one eye on bonds, even if they never plan on trading a single one.
You’ve probably heard the old saying that the bond market is smarter than the stock market. I don’t think bond investors are magically smarter people.
But there’s a reason that saying exists. The credit market is so large and so interconnected that when something’s wrong, there’s nowhere to hide.
If there is real pain coming, it will show up in credit spreads.
And that makes them one of the most important stress gauges we have.
So the question is simple: Are we seeing any signs of stress right now?
Let’s look at the evidence.
Tightest Credit Spreads Since February
There are many ways to measure credit spreads, but the idea is always the same.
We want to know how much extra yield investors demand to own risky bonds instead of the safest bonds available.
In this case, we’re focusing on high-yield corporate bonds, which is simply a more polite name for junk bonds. They’re the same thing.
To measure stress, we compare the yields on these riskier bonds to the yields on government-backed U.S. Treasury bonds.
When investors are nervous, they demand more compensation to take risk, and credit spreads widen. When investors are comfortable, spreads tighten.
One clean way to track this is by looking at the ratio of the High-Yield Corporate Bond ETF (HYG) to the 3-7 Year U.S. Treasury Bond ETF (IEI).
That ratio just reached its highest level since last February:
This is the opposite of stress.
Tightening spreads tell us that investors are comfortable owning risk. Capital is flowing toward junk bonds, not away from them.
That’s not what markets look like when trouble is brewing.
What we watch for are divergences.
If stocks are pushing higher while this ratio starts to roll over, that can be an early warning sign that something is changing beneath the surface.
So far, there is no such signal.
Credit is calm. And when credit is calm, the market is not under real stress.
Weight of the Evidence
Yes, there are some potential divergences showing up in equities. We’ve already talked through them this week, and they are worth monitoring.
But if those divergences were signaling something more serious, we’d expect to see confirmation from credit.
That would show up as widening spreads, meaning the ratio above rolling over and heading lower.
That’s not what’s happening.
Instead, we’re looking at one of the calmest, least-stressed bond markets we’ve seen in almost a year.
Credit spreads are tight. Risk is being embraced, not avoided.
And, to be clear, a calm bond market doesn’t mean chaos is lurking around the corner. That’s not how this works.
Stress doesn’t appear out of nowhere in stocks. It usually shows up in bonds first, then spills over into equities.
That’s why we treat credit as a leading or coincident indicator. Right now, it’s not flashing any warnings.
The weight of the evidence says the same thing.
If there is real stress coming for markets, it will show up in credit.
And it’s not showing up yet.
Stay sharp,
JC Parets, CMT
Founder, TrendLabs