How to Spot Market Tops: Interest Rate Spreads
Over the past several days, we discussed 4 ways to identify market tops: macroeconomic indicators, interest rate raising cycles, valuation metrics and market sentiment. Here, on the 5th and last part of this series, we will analyse interest rate spreads and see what they tell us about the current market.
1. High Yield Spreads
Rapidly rising interest rate spreads between corporate bonds (high yield) and US Treasury bonds are often an indicator that economic conditions may be about to turn. They could also indicate that the stock market may be about to peak. When investors anticipate that economic conditions will deteriorate, they switch from higher-risk corporate bonds into safe US government debt. This increases corporate bond yields and decreases US treasury yields, widening the spread between the two.
As we can see from the chart below, the last two recessions were preceded by a persistent rise in high yield spreads.
Source: Federal Reserve Bank of St. Louis
Today, however, these spreads are still close to historical lows, which indicates that we might be still some time away from a market top. In fact, if we compare the current spreads with equivalent periods in the past, we see that spreads were lower only about 34% of the time. Therefore, we should expect high yield spreads to start increasing soon, which should give the current bull market further room to run.
Source: Guggenheim High-Yield and Bank Loan Outlook April 2017
2. Loan Spreads and Default Rates
Another way to look at the current cycle is to consider the spread between bank loans to individuals and corporations, and the rate at which banks lend to each other (LIBOR). In general, increasing spreads suggest higher risk in the economy. At the moment, loan spreads are tightening, and default rates are low, once again indicating that it is not yet time to be running for the exits.
US loan spread over LIBOR
Source: UBS High yield bonds , April 2017
US loan default rate
Source: UBS High yield bonds , April 2017
3. Yield Curve
Finally, another very important way to detect market tops is the spread between long-term and short-term US treasury yields. According to Charlie Bilello of Pension Partners, the past 9 US recessions were all predicted by yield curve inversion (defined by a negative spread between long-term and short-term yields). The average lead time was 14 months.
Source: Federal Reserve Bank of St. Louis
More significantly, in the past 9 recessions, yield curve inversion preceded a stock market peak 6 times, with an average lead time of 7 months.
Source: Charlie Bilello 2014, Pension Partners
Currently, the yield curve is quite some distance away from inversion, although it is starting to show some signs of flattening, meaning we should watch this indicator closely.
However, overall, we see that most indicators show that we are still quite some distance away form a market peak, and that the current bull market still has room to run.