US Corporate Bond Spreads Widening…..Finally

Last week the S&P500’s bounce came to an abrupt end. The large cap index gave back 1.6%, on moderate volume. Volatility did jump on the worst sell of days, but it did come back down on Friday when prices recovered a bit.

As usual, US economic reports were mixed. Consumer prices came in exactly as expected—up slightly from last month’s reading. The same thing happened with core consumer prices. Retail sales beat consensus estimates. So did the Empire State manufacturing survey. On the downside, initial jobless claims were slightly worse that expected. Industrial production also missed expectations….as did the Philly Fed business outlook survey. More importantly, on a year over year basis, several key US economic indicators are still showing growth. This means that our Simple Rule has not yet switched away from being bullish, long-term, the S&P500 index.

On a shorter term basis, the daily charts of the S&P500 are now somewhat murky—they are not strongly bullish or bearish. We’ll need another week of actual results to make a more definitive call. On the weekly charts, charts that provide a medium-term outlook, the forecast for the S&P500 is still somewhat bearish. The damage from October is still far from being repaired. This suggests that the usual seasonal Santa Claus rally through the end of the year may be in jeopardy or may not be as pronounced as it has been in prior years.

Finally, something interesting has just started to happen in the US corporate bond markets. When the S&P500 first corrected in late January and early February, US corporate bond prices barely budged. In fact, these bond prices not only held strong throughout the equity sell-off, they actually rallied into the summer months. And even when the US equity markets took another dive in early October, just last month, US corporate bond prices held firm.

Until now.

Over the last two weeks, the high yield spread has widened out to its highest level in almost two years. The same has occurred with the investment grade bond market. With high yield bond prices especially, there tends to be a strong positive correlation with US equity prices. And for much of the year, this correlation broke down. But now that corporate bond prices are beginning to sell off, the concern is that the corporate bond market is validating the weakness in the US stock market. And unfortunately, this does not bode well for future US stock market prices. Now that both markets are getting into sync with each other, US stock market investors and traders will be more likely to sell down their stock market exposure even further….leading to additional price drops in the US stock markets, at least in the short to medium term.

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