On credit spreads: Narrow, widen, repeat and die?

While it may be one thing for the S&P 500 to fall 1.9% in one day as it did on Friday, it is quite another when it happens as bonds soar, the Treasury curve inverts and credit spreads widen. That combination was in full effect Friday and has put global investors on edge. So, does this signal the death of the 2019 stock market rally? In his Friday evening March 22nd broadcast, Bob Hoye from chartsandmarkets.com is watching for the next move in credit spreads for clues.

While stocks tumbled Friday, the 3 to 7-year Treasury ETF soared as the yield curve inverted

As is usual, the market historian looks at where we have been in order to narrow down the possibilities of what might happen next.

Drawing on his firm's yield curve history that goes back to 1860, he notes that generally in a boom, short rates go up because there is an increasing demand for speculators to get leverage. As the boom peaks, that all changes. On the significance of the yield curve inversion, Hoye warns that the Fed is not in control of things:

The Federal Reserve has no control over the yield curve as you approach a cyclical peak, that's why they happen; the other thing is they have no control over credit spreads, that's all in the market, the public determines that.

Based on their historical work, Hoye believes that there were important developments in the yield curve took place long before this week.

Our work on the yield with history going way back was that you didn't need to have the curve actually invert. In a boom it flattens, but there are examples in history where the curve approached inversion and the key thing is when it reversed. And this is what happened last summer. That to us was the signal, plus when credit spreads started to widen.

Now, we have an actual inversion which has everyone talking. On credit spreads, Hoye suggests that in order to change the trend to an adverse one, often it takes two breakouts. Last year, the rapid deterioration of credit late in the year was proceeded by a summer breakout in June and the second breakout in the early fall. As for 2019, Hoye notes that spreads have narrowed into March but are now on a possible reversal to adversity as we have had the first breakout in spreads widening. He is now watching for the second break and will be alerting his clients if it happens:

That one could be the killer. We don't know at this point if comes next month, May or who knows when.

Hoye notes that reverses in the credit markets are often associated with bear markets for stocks which is also associated with recessions.

Earlier in the week in his Wednesday broadcast, Mish Shedlock from MishTalk reported that there were already 22 yield curve inversions in place. That was before Friday's bond yield carnage. Commenting on implications of the yield curve moves indicating a recession, Mish suggests:

It is not crystal clear that we are in one now, but it would not surprise me say two or three months from now to have one back dated to February or March this year.

Going forward, he is keeping a close eye on housing and manufacturing. The market seems to be as well. In our view, Friday's stock market sell-off suggests investors are putting more emphasis on manufacturing, likely because PMIs disappointed not only in United States, but also in Europe and Asia. As Mish says, "the US is not going to be immune to all of these things".

Putting it all together, we believe the big question for investors is whether the Fed reversed course quick enough to avert Hoye's dreaded second breakout in credit spreads. Insider sentiment as of last week were mixed on the big-picture outlook. The best case going forward would be that they shrug off last week's volatility as business-as-usual. As for us, we won't be missing a beat as we update our Canadian insider signals Monday and American signals Wednesday in our market updates.