Diary of a Financier

Credit spreads & inflation expectations: Launching the blowoff top

In Economics on Fri 3 May 2013 at 16:09

With a +1.2% SPX rally on the heels of today’s upbeat jobs report, are we transcending Excitement for Thill on the Investor’s Cycle of Psychology? Not quite yet, but soon. (I still expect that to occur after a July correction.) With the 10-year Treasury yield ($TNX) having dropped to ~1.62% yesterday, bond prices have continued to positively correlate with equities, redoubling the groans from those who wield the “bond bubble” meme. I wanted to take a new look at credit spreads and inflation to get a better feel for where we stand in a progression toward a major market top.

Spreads are incredibly thin, but I’ve maintained our fixed income allocations [almost entirely] in High Yield ($HYG) and Senior Floating Rate Bank Loans ($BKLN), because, as I said in February, “I believe the credit cycle is only in its 6th inning.” Risk has continued to rally accordingly, entering the 7th inning perhaps, so I stand by my aversion to high grade, my preference for buying fallen angels on dips.

Investment grade corporate bond spreads are not historically low (tight); they’re not even near decade lows. With risk free rates at the zero bound ZIRP, relative bond spreads are a more relevant tool, and those IG relative spreads are far below historical lows. This plus relative value tells me not to buy AA paper. In terms of what this means for the credit cycle, I included the IG spread/SPX ratio to see if anything was wildly amiss relative to an even higher risk sphere, and it’s not [yet]. The ratio is trending along a level commensurate with normal, boom times:

IG credit- absolute spreads (blue), relative spreads (red), spread/SPX (green)

IG credit- absolute spreads (blue), relative spreads (red), spread/SPX (green)

Next, High Yield absolute spreads are still far wider (higher) than historic troughs, and relative spreads have slipped just below historic lows. As with IG, the HY spread/SPX ratio is also consistent with normal market booms, although it has just grazed the upper bound from 2006-07’s euphoric range:

HY credit- absolute spreads (blue), relative spreads (red), spread/SPX (green)

HY credit- absolute spreads (blue), relative spreads (red), spread/SPX (green)

I have an observation I wanted to note from those two charts. When SPX (the denominator) went parabolic into its blowoff top, HY spreads (the numerator) moved sideways. Consequently, the HY spread/SPX ratio quickly dipped lower before spreads subsequently blew out and SPX plunged (even) lower. On the other hand, I notice that IG relative spreads actually widened during the better years of the last cyclical bull market (likely due to investors trading up for more risk), which kept the IG spread/SPX ratio steady throughout. This IG widening in the face of HY tightening (and SPX rallying) may be an important early warning sign–a signal I’ll keep in mind for spotting the end of the credit cycle. With the Fed enforcing ZIRP per QE, IG widening should not persist for as long as it did in 2004-07. The boom should go bust much sooner after this indicator starts screaming.


There’s also inflation. A lot of [bearish] analysts have pointed out the 5y5y/SPX divergence. In March, I was all over the dip in 5y5y, and it didn’t alarm me:

“If 5y5y can hold around 2.50%, then the Fed has successfully managed price levels (half of its dual mandate–employment being the other). If 5y5y continues sliding lower, then the $85B/month flow from open-ended QE3+4 will likely be increased.”

I’ve always used 5y5y forward inflation as the most prominent gauge of expected inflation. I also look at indicators like CPI (backward looking) and 10y TIPS breakevens¹ (forward looking). I scanned the history of the latter–10y breakevens–to find patterns reminiscent of today’s and get a sense for the longer-term outcome. I found two prior periods that echoed the ascending triangle pattern exhibited today, so I overlayed the 10y breakeven index vs. SPX to evaluate the relationship between the two. You can see that a breakout from the ascending triangle pattern in 10y breakevens predicates/coincides with an acceleration in the SPX rally. You can also note the persistent erosion in the ratio between the two (10y breakevens/SPX). The pickup in inflation expectations goes hand-in-hand with equities launching into a blowoff top:

10y TIPS breakeven v SPX

10y TIPS breakeven v SPX

I’ve continually tried to disprove my 2006 analogue thesis, but the supporting evidence keeps stacking up. The aforementioned jobs report today compounded with the other macro catalysts I keep discussing have me expecting a continued SPX launch this year, led first by a rally in inflation expectations (e.g. 10y breakevens and 5y5y to a lesser extent).


¹Dow Jones Credit Suisse 10-year Inflation Breakeven Index, inception 1997

  1. Hi Romeo, thank you for sharing your market views. Although many expecting the market to roll over, what would you say about this:
    Posted by Steven Vincent on April 29, 2013 at 12:00pm

    In the March 10 BullBear Market Report, I concluded that the US equities markets had ended the long term bear market that started in 2000 with the November 2012 low and had begun a new, secular bull market:
    This report comes down on the side of concluding that indeed a new, secular Bull Market has begun. While there is still some chance that a bear market (D) wave top could come in the vicinity of the 2007 highs, evidence is mounting that the 2011-2012 period was an (E) wave of a long term triangle and that recent price breakouts and changes to the technical character of the market mark the start of a very long term Major (V) bull market. The Dow Jones Industrial Average appears to be projecting to a completion of the ongoing bull market from the 1932 low in the area of 18,800 in the late 2015-early 2016 time frame.
    If a market has transitioned into a new phase, then indicators should be expected to behave differently. We are already seeing that many technical conditions which had previously been solid markers of a top are no longer. One of the mistakes that analysts are likely to make in the coming months is that they will be relying on bear market methodologies to trade bull market conditions. We are going to need to look for new setups to trade this bull effectively.
    In the April 3rd BullBear Market Report, I called for the continuation of an intermediate term correction of the move off the November low:
    My current analysis is that the S&P 500 has reached an intermediate term top in the context of the early stages of a impulsive bull market wave. The latest technical development supporting the bull market thesis is that we have seen the completion of a rather clear Elliott Wave 5 sequence bullish impulsive wave with subwaves that also show bullish impulsive structures and characteristics. On March 15th the market began a Wave 2 correction of the Wave 1 that started in November 2012. This corrective wave could be expected to last an additional 3-6 weeks and should retrace about 38.2% of Wave 1.
    Three weeks later, it appears likely that the intermediate term correction may be over. SPX has apparently corrected in a sideways triangle within a bullish parallel channel. The correction did not approach the minimum 23.6% retracement generally associated with an intermediate term correction and did not break horizontal or channel support (at least not yet, anyway). The wave corrected just 14% of the prior move at its maximum depth. There has been a decent correction of technical indicators, however, on the daily and weekly time frames, such that the market is no longer overextended.
    In the March report, I warned that technical setups that had worked for intermediate term trading during the bear market may no longer be applicable:
    If a market has transitioned into a new phase, then indicators should be expected to behave differently. We are already seeing that many technical conditions which had previously been solid markers of a top are no longer. One of the mistakes that analysts are likely to make in the coming months is that they will be relying on bear market methodologies to trade bull market conditions. We are going to need to look for new setups to trade this bull effectively. Fortunately, if we are in an impulsive bullish environment, longer hold times will be possible and fewer trades will be necessary.
    Indeed, the technical setup we saw beginning with the March 15 top was identical to that which had pertained to the 2010, 2011 and 2012 tops, yet in this case we did not see the same intermediate term price correction but rather a minor correction within the trend. This sets up the potential for a breakout above the 2007 highs after a 5 week consolidation and if this happens it would come in a powerful Wave 3 position in the context of an extended Wave (1). That means a large, strong, persistent bull move may be on the calendar in the near term….

    • Hi Victor–
      Good other from you. Hope all is well. I don’t subscribe to Elliot Wave Theory, because I’ve found it too rigid, inflexible, and just doesn’t work. In addition, it’s really hard to look into the long term with conviction, due to the butterfly effect and sensitivity to initial conditions.

      That said, I did post earlier this week to update a series I’d been harping on about the longer term demons SPX had been fighting, manifest in bear divergence that started in 2011 for the weekly chart & 1999 for the monthly. Both concerns have been reversed recently, and although I see some troubling bear divergence that’ll bite the daily chart for a mid-May pullback & the weekly for a July correction, the longer term leads much higher.


  2. […] in coordinating all the other signals I’ve found in my multistrategy assessment; things like credit spreads, inflation expectations, sentiment/psychology, growth vs value, and long term technicals are all consistant with the 2006 […]

  3. […] opinion is that systemic defaults are not an imminent risk today. (I’m on the record as saying that I think it’s only around 7th inning of the credit cycle, for a myriad of reasons, and […]


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