Hey There Income Hunters,
Banks in the US and Europe continue to get pounced on.
And it’s for good reason – bank credit spreads are widening at a fast clip.
You see, credit default swaps (CDS) are a critical signpost for default and insolvency issues in the financial system.
A CDS contract brings a buyer and a seller of protection against a counterparty default together.
The buyer pays an annual premium and the seller agrees to pay a lump sum payment based on credit conditions (i.e. filing for bankruptcy).
When the premium rises, that signals weakening financial conditions on the counterparty in question.
Check out the rise in insurance premiums of some of the largest banks in the world.
Today, we will look at the major symposts for the economy and banking system that are signaling danger.
Energy Prices Signaling Recession
Crude oil spikes over the past few decades have all led to recession. This highlights the demand destruction from higher consumer prices.
We are at a 50% deviation from trend and still ripping higher. Each time oil made a similar move, the economy went into recession (1971, ‘74, ‘80, ‘00 and ‘08).
High Yield Spreads Widening
The high yield vs investment-grade-option adjusted spread is back to levels reached during March 2020.
This spread also speaks to corporate bond credit risk. High yield is first to fall and spread to safer corporate bonds.
You can see in the chart below the massive move from an all-time high.
This spread signals that the iShares Investment Grade Bond ETF (Ticker: LQD) is a good outright short on rallies or as a paired short versus a long in the iShares 7-10yr Treasury Bond ETF (Ticker: IEF).
The LQD/IEF ratio shown in the chart below has already broken down and looks like it is hanging on by a thread. LQD is an ETF that is loaded with BBB corporate bonds and many of them will be downgraded in recession.
Once the downgrades begin, LQD could really fall apart as market makers will have trouble liquidating so many illiquid bonds.
Bring It Home
The next couple of weeks will bring tons of important data, including CPI next Thursday. We will also see huge bond supply sold by the Treasury into a market with volatility at lofty levels.
Then the week after will option expiry, which has been super volatile at all.
Here is what we know …
Inflation will now remain elevated as growth slows. This is an impossible situation for the Fed, and no matter what, the next 2 months will be really hard on stocks as growth plummets in Q1 and Q2.
Long metals and energy and short equities continue to be a high probability trade. With the mega cap growth stocks joining the bear trend, SPY may be a good bet to trade down to 3,800 in the weeks ahead.
Stay with me here for how to trade and profit! And feel free to email me with any questions.
Have a great weekend and as always …
Live and Trade With Passion My Friend,
Griff