A Twitch of a Toe
In our recent update on credit spreads we proposed to use the seemingly deceased Monty Python parrot Polly as a stand-in for the suspicion of creditors in today’s markets.The question was whether Polly was indeed dead or merely in a deep coma. Depending on this, one should be able to gauge how powerful a miracle will be required to resurrect her.
Meet Polly. Is she alive?
In the first half of November there was actually a small sign that Polly is perhaps not completely dead just yet. Essentially one of her toes could be seen twitching a little bit. In short, credit spreads started to widen, eventually challenged nearby resistance, but failed to overcome it.
US junk bond spreads – the red lines represent the lateral resistance area that needs to be watched. In early November it was challenged for the third time since the sideways move began. As we have , historical data suggest that when junk bond spreads become extremely compressed, a move above nearby resistance that is sustained after a retest is all it takes to trigger an avalanche
There is no cause for alarm yet, as resistance has obviously held – but past examples of similar situations suggest that it won’t take a great many tests of resistance before a breakthrough actually happens. In other words, it is time to pay close attention.
It is worth noting that there was no obvious “reason” for the recent move. The ECB’s announcement in late October that it would run its printing press at half-speed from the beginning of next year and offset that (once again) by letting the purchase program run longer than originally planned, was seen as dovish by the markets – spreads initially tightened further. They only began widening about a week later. The way we see it is as follows: once spreads begin to move sideways at an extremely compressed level, the distribution phase is underway.
As an aside, keep in mind that junk bond yields were never lower in absolute terms. It is a good bet that the “smart money” is busy selling to those who erroneously think European junk bonds shouldn’t yield more than US treasury bonds. Here is what happened with credit spreads in the euro area:
Euro area junk bond spreads tested initial resistance as well, which has also held for now
Lastly, spreads on the lowest-rated junk bonds corrected the most and actually breached initial resistance briefly. Note that they have already diverged bearishly from the rest of the junk bond universe this year on several occasions, by making higher lows concurrently with spreads on higher rated junk bonds reaching new lows for the move.
Spreads on US junk bonds rated CCC and lower – there is a subtle difference in the behavior of these spreads and those on better rated junk bonds. From experience we know that such subtle signals in retrospect often turn out to have been important – which is why we prefer to discuss them sooner rather than later
