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The Bond Market Points to a Stock Market Correction

From the Desk of Ian Culley @IanCulley

Mark it, Dude.

We have another bearish divergence calling strike three on the stock market rally…

High-yield bonds $HYG versus US Treasuries $IEI.

Check out the HYG/IEI ratio (dark blue line) overlaid with the S&P 500 ETF $SPY:

We use the HY bond-to-US Treasury ratio to track credit spreads. When the dark blue line falls, credit spreads widen – a sign of dwindling liquidity and stress for the bond market (the world’s largest market).

Stocks tend to struggle as credit spreads widen. 

On the flip side, when these spreads contract (or the HYG/IEI ratio catches higher) stocks rally as capital flows into risk assets. That’s why these two lines trend together. 

Notice the HYG/IEI ratio and SPY bottomed last October before rallying into the spring, following a similar path to new highs. 

But while the S&P 500 hit another all-time high this week, the HY bond-to-US Treasury ratio peaked in late April.

Plus, bullish momentum is deteriorating:

HYG/IEI is carving out a short-term top. 

However, the ratio must post a clear downside resolution before we can add conviction to a near-term bearish thesis for the US stock indexes.

Meanwhile, the Emerging Market Bond ETF $EMB versus US Treasuries $IEF (another credit spread proxy) is challenging fresh three-month lows:

At a glance, divergences often occur between the two, especially at critical turning points.

The EMB/IEF ratio led the SPY into the 2022 top and bottomed in July of the same year – three months before the stock market.

But, these dislocations are short-lived while a positive correlation dominates over longer time frames.

Other market areas are also throwing doubt at the stock market’s new all-time highs.

Breadth is deteriorating beneath the surface as the NYSE advance-decline line prints a bearish divergence. The Dow Transportation Average hovers just above a fresh year-to-date low. And Bitcoin (a risk asset’s risk asset) is failing to join the Nasdaq 100 rally. 

It doesn’t mean the stock market will collapse in the coming weeks. 

Instead, you can think of these divergences as flashing yellow lights. 

The alarm bells have yet to sound. But it’s time to pay attention.


Countdown to FOMC

The market is pricing the probability of the first 25-basis-point rate cut for the September meeting.

Here are the target rate probabilities based on fed funds futures:

Click the table to enlarge the view.

This data is from the CME FedWatch Tool as of June 20, 2024.

Thanks for reading.

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The post The Bond Market Points to a Stock Market Correction appeared first on All Star Charts.

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