A U.S. options strategist warns of potential downside for equity markets in the next three months, based on current credit market signals. Credit spreads are extremely tight, indicating that corporate bond investors are accepting smaller extra yields over government bonds.
When credit spreads are tight, it suggests optimism, which might not match the current economic outlook. Asset managers are cautious, limiting exposure to high-yield credit due to the risk of slowed growth and increased defaults. Historically, changes in credit indices like CDX and iTraxx can precede volatility in stocks.
Credit Market Benchmarks
The ICE BofA U.S. High Yield and Corporate Option-Adjusted Spreads, available on the Federal Reserve Economic Data site, can serve as benchmarks. Rising spreads typically indicate cooling risk appetite and potential market stress.
Markets also watch inflation reports influencing interest rate expectations, affecting bond yields and spreads. Investors are encouraged to monitor credit spreads and inflation reports, as divergences between equities and credit spreads can indicate market fragility.
By tracking credit spread movements and understanding indices like CDX and iTraxx, investors can gauge early warning signs in credit markets and better assess risks in their portfolios.
Credit markets are signaling potential trouble for stocks over the next few months, so we need to be prepared. Corporate bond investors are accepting historically small extra yields, a sign of optimism that may not be justified. This tightness in credit spreads leaves the market vulnerable if economic growth slows down.
The ICE BofA high-yield spread is currently just 305 basis points, a level that reminds us of the complacency seen in late 2021 before the rate hikes of 2022. At the same time, the CDX Investment Grade index is trading near 50 basis points while the S&P 500 pushes past 6,200. This kind of disconnect, where credit markets are stretched thin while stocks soar, often ends with a sharp correction.
Strategies for Navigating Volatility
This presents a clear warning for derivative traders, especially with the VIX index hovering near a low of 13. Equity options seem to be underpricing the risk that the credit market is flagging. We saw a similar pattern before the downturn in early 2022, where credit spreads began widening weeks before the equity market took a significant hit.
The U.S. inflation report due tomorrow, August 12th, is the immediate catalyst we are watching. A number coming in hotter than the expected 2.8% year-over-year could be the trigger that causes spreads to widen rapidly. Such a move would almost certainly translate into a spike in equity volatility.
Given this risk, we believe it is a good time to purchase some downside protection. Buying out-of-the-money put options on the SPX or QQQ with September or October expirations is a straightforward way to hedge a long portfolio. The current low volatility makes these protective options relatively cheap.
Another strategy is to look directly at volatility itself through VIX derivatives. With market fear so low, buying VIX call options for the coming weeks offers a cost-effective way to position for a sudden shock. If credit spreads do start to blow out, the VIX would likely be the first indicator to jump.
It is critical to watch the key credit benchmarks like the high-yield option-adjusted spread on FRED each day. If we see equities rally after the inflation report but credit spreads do not tighten to confirm the move, that rally is likely fragile. This would be a signal to consider fading the move with bearish call spreads.
