Weakness in high-yield bonds signals greater volatility for the stock market

High yield bonds (also called junk bonds) are often used as an indicator of risk sentiment or risk aversion. However, as high yield bonds are very sensitive to market liquidity, it is a reliable indicator to give an early warning of potential liquidity problem in the stock market.

Refer to the table below to see how the High Yield Bond (HYG) performs in the event of a reduction in the bond buying program and quantitative tightening by the Federal Reserve (Fed).

Divergence between high yield bonds and the S&P 500

As shown in the chart below, the divergence (highlighted as an orange arrow) between high yield bonds (HYG) and the S&P 500 (SPX) played out in 2014-2015, 2017-2018 and 2021, where the S&P 500 formed higher highs while the HYG formed flat tops. .

Pullbacks (highlighted in pink) of relatively large magnitude were seen as HYG struggled to rally to catch up with the S&P 500. Divergence as well as significant pullbacks in the HYG signaled red flags for the S&P 500. Subsequently, the S&P 500 suffered a 12% correction from the highs of 2015, 2018 and 2022.

In 2014, the reduction in the Fed’s monthly bond-buying program in response to the 2008 global financial crisis, which ran from January to October 2014, lasted 10 months. In 2018, the Fed carried out quantitative tightening in order to reduce its balance sheet.

The tightening of monetary policy by the Fed caused the market to correct more than 10% with an increase in volatility, as evidenced by the trading range formed in the S&P 500 in 2015-2016 and 2018-2019.

Now, in addition to the reduction in the bond-buying program which is due to end in March 2022, the Fed is also considering quantitative tightening to reduce the balance sheet. Besides that. a rate hike is likely to occur in March 2022.

The rapid pace of rate cuts, tightening and hikes is expected to stoke more volatility in the stock market, which is currently unfolding where the S&P 500 just suffered a sharp correction in January 2022.

Prior to the sharp correction in the S&P 500, high yield bonds (HYG) were already giving an early warning by producing several significant pullbacks on top of the divergence with the S&P 500.

Over the past 3 weeks, despite the market rebounding from the oversold, the selloff in high yield bonds (HYG) has continued, which could indicate further weakness in the S&P 500. In order to better predict the short-term trend of S&P 500, the Wyckoff method is adopted for detailed analysis below.

S&P 500 price prediction with the Wyckoff method

Based on Wyckoff phase analysis, the S&P 500 experienced a selling high (SC) on January 24 followed by an automatic rally (AR), which is a technical rally after an oversold condition. 4550-4600 (as highlighted in red) is the resistance area where the previous breakdown occurred, which is an important level to overcome for a bullish swing. Refer to the table below:

Last week there was an attempt to break the resistance zone at 4550-4600 but failed with two bearish bars with increasing volume suggesting the presence of supply.

Increasing volatility in both directions is one of the main characteristics of a bearish rally. The bearish rally, as reflected in the automatic rally (AR), made it difficult for short sellers to cover their short positions while attracting traders and investors hoping for a V-shaped bounce. Market outlook video on how to interpret supply and demand volume as well as price movement to better anticipate the movement of the S&P 500.

Last Friday, the bearish bar broke through the intermediate support level at 4450 suggesting a test of the low formed by the high point of the selloff as a secondary test (ST). So far, the S&P 500 is still in a trading range between 4250 and 4600. Meanwhile, oil-related stocks still outperform where there are plenty of valid low-risk trade entry setups with a decent reward-to-risk ratio thanks to the high price of crude oil. The upward tracking is likely to continue for oil stocks. Visit TradePrecise.com for free more market information via email.

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