Above the noise: Bond market is signalling risk-off in equities
As regular readers of the Above the Noise blog may have noticed, I have been negative on equities since late September, and have made several comments about the discrepancy between the change in global equities and the change in economic expectations among German export companies.
Another relationship that my good colleague John Hardy was so kind to highlight today is the action in corporate bond spreads (see chart below). The chart shows the spread in basis points between Moody's Corporate Bond BAA and AAA yield index versus the S&P 500 index (BAA is the notch just above non.investment grade bonds, red. speculative). The relationship is clearly inverse, which we would expect, as widening bond spreads signal rising risk-off environment and increased risk premium on credit risk which is naturally bearish for equities. However, the relationship is coincident and as such neither of the time-series can be used to predict the other. Maybe from time to time the one will lead the other but it would not be a robust indicator. It could easily change.
If they are coincident what can we use the chart for? Well, the corporate bond spread has generally a more smooth nature compared to moving averages used to gauge the overall direction in equities. This takes out more noise and reduces the likelihood of false positives from other technical indicators. This is important in rejecting short-term rallies in downward trends.
The recent upward move in the bond spread is confirming that the risk premium on credit risk is rising and the rate of change in the spread is consistently positive over the last couple of weeks, indicating that a change is likely happening. If we buy the myth that bond investors are normally more rational than equity investors and do a better job of discounting the near-term future in the economy, then the latest move in the bond spread is confirming that we are still in a risk-off environment in equities. In other words our call from late September suggesting that global equities had probably reached their top for the year seems to be holding up. Our call, in fact, said that equities would be perform badly over a 5-6 months period.
With this in mind we reiterate our stance that equities could continue to fall and downside risk is still higher than upside risk.