BULLISH SETUP ON HY-IG SPREAD EMERGING. (BEARISH EQUITIES)Back in November of 2022 I wrote about using the HY-IG spread as a potential indicator of 'risk on' vs. 'risk off' sentiment and I will insert that below for readers trying to understand how this spread differential can be utilized. Subsequently I will explain what I currently see emerging on the above chart with the addition of both the RSI and correlation indicators to provide a more robust and predictive analysis than using the HY-IG options adjusted spread alone.
Written November 2022 - 'When the spread between High-Yield (HY) debt and Investment Grade (IG) debt contracts or expands, this can be perceived as the market demanding more or less compensation for the risk it perceives to be present in owning the HY debt against the IG corporate debt. (HY-IG) = Risk On/Risk Off market sentiment.
Generally speaking HY debt a.k.a. Junk Debt, is considered more risky than IG debt. Because of this increased risk, the market demands a higher yield for taking on HY debt, also known as a ‘risk premium’ or ‘premium’ over the alternative investment opportunities the market provides.
This yield premium on HY/JunkBonds can be viewed as ‘extra incentive’ for bids to take on the ‘riskier debt’. When this spread (white) contracts, we can see that the market (yellow) has a tendency to go up (risk on) and when the spread (white) expands we can see the market (white) has a tendency to go down (risk off). This is only one of many indicators I use to gauge ‘market risk sentiment’ and I thought I would share it.' (I have included the link to this piece for reference at the bottom of the page and please excuse the extra charting as I was new to the platform at the time and included the second chart and indicators, but the words remain the same.)
Now that the fundamental use case of the HY-IG spread is explained we can dive in to the current situation. As we can see the HY-IG spread called the late October2023 bottom in the AMEX:SPY (orange), as the spread peaked, the broader equity markets found their bottom. This is not always as direct and their is often a bit of a latency where equities will begin to trend upward before the spread peaks due to the forward looking nature of equity markets, however in October of 2023 the spread nailed the bottom.
As of today, February 27th, 2024, the HY-IG spread has made a 'lower low' down to 2.27 which gives us a bullish price to RSI divergence on the HY-IG options adjusted spread. The HY-IG spread has made a 'lower low' while the RSI is still printing 'higher lows'. In this particular instance, a bullish divergence on the HY-IG spread could signal a bearish sentiment for broader equity markets ( AMEX:SPY ) at some point over the next 4 to 6 weeks which is the normal time latency between a peak or trough in the options adjusted spread and the time it takes to show up in the price action of equity markets. This divergence theory would be invalidated with an RSI reading below 25 by the HY-IG spread. A reading below 25 would make a lower low on the RSI and would invalidate any divergence.
Finally we can look at the correlation (bottom indicator) and see that HY-IG is inversely correlated to the broader equity markets as represented by AMEX:SPY at (-0.92) over the last twenty trading days and has maintained a relatively consistent and significant inverse correlation to AMEX:SPY over the majority of the last year. While I did not include the tech laden NASDAQ:QQQ on the chart, the inverse correlation is still very significant at (-0.87) at the time I am writing this article. This assumes 'corollary significance' is achieved at a greater than or equal to (0.62) level.
Given the further contraction in the options adjusted spread down to the 2.27 level, its possible we have a bit more upside room to run in equities, however, assuming the RSI divergence holds with 'higher lows', it's unlikely that we don't see a move to the upside in the HY-IG spread over the next 4 to 6 weeks, which is generally a bearish signal for equities markets. I hope you enjoyed this piece and I welcome any feedback or suggestions you might have so that I might improve further articles. Thank you for reading and happy trading!
