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:
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:
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:
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