Bond Markets Flashing Danger Signs

Hey There Income Hunters,

 

There’s a warning sign flashing.

 

I picked it up from the US Bond Market Option Volatility Estimate (MOVE) index.

 

MOVE is considered the VIX for bonds and yesterday it recorded a high that had not been reached since March 2020. 

 

The MOVE index has been high for weeks while the volatility of the S&P 500 (Ticker: VIX) was hovering near year lows. 

 

As you can see, spikes in bond vol provide warning signs for spikes in stock vol …

 

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Today, we’ll take a look at a couple of other bond signposts that can provide ideas for trading stocks and bonds. 

 

Bond Market Rules of the Road

 

There is a fundamental connection between bond and stock volatility, and it is this:

 

The Weighted Average Cost of Capital (WACC) — the combined debt and equity returns required by the market for a company to fund itself. 

 

In other words, as the value of the stock goes down, the risk of the interest rate on its debt rising goes up.

 

On the other hand, if the interest rate on its debt rises, debt financing risks rise, and this must be accounted for in valuation of the stock.

This is all in theory, and as we have seen, a market can stay irrational longer than speculators can stay solvent.

 

However, all else being equal, under the WACC, if interest rates rise, the cost of financing business goes up and sends stocks lower. 

 

The risk of stocks going lower as interest rates rise is higher now because of the Fed taper and uncertainty surrounding Washington and the debt ceiling.

 

Historic Levels of Corporate Debt 

 

The corporate bond market is bursting at the seams, with leverage at historical extremes. 

 

Check out the corporate debt-to-US income-ratio as measure by gross domestic product (GDP). It is incredible to see that corporations are 25% MORE leveraged today than during the dot-com bubble … 

 

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Now, we know the Fed will come to the rescue with a helicopter drop of new money. The key is to lighten up and even catch a bit of the correction so you can turn around and jump on the ride back up. 

 

Here is an important signpost for potential problems developing in the market …

 

Corporate Bond Market Signpost

 

The corporate bond market and housing market are the most sensitive to a rise in interest rates.

 

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This may end up being a fake breakout but if the outright breaks above 2.5% it will take on more urgency.

 

iShares Investment Grade Corporate Bond ETF (Ticker: LQD)

 

LQD is an excellent ETF to trade as a proxy for corporate bonds. Over 50% of the holdings in the ETF are BBB credit bonds. 

 

When the corporate debt burden becomes a problem and BBB rated bonds get downgraded LQD will trend down hard. This is because funds holding BBB bonds, which are the lowest rated “investment grade” bonds, will be forced to sell, causing a meltdown in LQD

 

Market makers will be loaded with bonds that are plunging and will drop their bids for LQD to account for the markdown in the inventory they hold from redemptions. 

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The graph above does not look like it is ready to break down. First of all, the volume after breaking the 200-day moving average is lower than average. 

 

Secondly, if LQD breaks the uptrend line and makes a new low it will trigger a positive relative strength index/price divergence as RSI would not make a higher low.

 

LQD is trading within a down channel, though, and the underlying conditions outlined above will eventually cause a breakdown.

 

So , LQD should be sold on rallies back towards 133 until it is able to break back above the 200 DMA on above-average volume.

 

Bring It Home

Understanding bonds and their impact on stocks was a game changer for my success as a trader. My Power Income Trader has this built in by focusing on the Fed, Government and Treasury’s policy. (Access to the program is currently closed)

 

We may see the TLT and LQD bottom this week, but that won’t change the overall debt picture.

 

I’ll leave you with the daily chart on the iShares Russell 2000 ETF (Ticker: IWM). 

 

It had the most bearish daily candle yesterday … a bearish engulfing pattern, which means the open was above the previous days close and the close was below the previous days open.

 

If you want some downside protection or to take a flier on a short-term correction, you could onsider a $IWN NOV22 234/232 put spread for $.69

      • Max Loss – $.69
      • Max Profit – $1.31 for a return of 189%

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Live and Trade With Passion My Friends,

 

Griff

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