The market could tank, according to signals coming from the credit market

Credit markets are flashing an early warning about financial conditions and the economy, but even as stocks fall in response, strategists say it’s not yet time to bail on Wall Street’s bull market.

But they do say there could be a pullback in a frothy market, and investors should take heed as some of the traditional signs of stress have shown up, such as a selloff in high yield debt, which often parallels weakness in stocks.

They also point to the flattening yield curve, a technical phenomenon when the yields of shorter-term Treasurys move closer to the yields of longer-dated notes. In this case the 2-year yield has moved higher, while the 10-year yield fell. On Tuesday the gap between the two narrowed to a 10-year low of just 63 basis points.

That’s important because a flattening curve is sometimes viewed as a warning about pending economic weakness. It is not viewed as truly problematic until the curve inverts, historically a sign of recession. The yield on the 2-year note has been moving higher lately in anticipation of a Federal Reserve interest rate hike in December.

Traders work on the floor at the closing bell of the Dow Industrial Average at the New York Stock Exchange on September 14, 2017 in New York.

Bryan R. Smith | AFP | Getty Images
Traders work on the floor at the closing bell of the Dow Industrial Average at the New York Stock Exchange on September 14, 2017 in New York.

“In terms of sheer price action and in terms of the yield curve, no I don’t think this is a dire warning yet,” said David Ader, macro strategist at Informa Financial Intelligence. “I’m not sure it’s telling you anything other than that in risk assets, there is clear evidence of froth.”

As buyers moved into the safety of bonds Tuesday, the S&P 500 lost as much as 21 points, but recovered and was just 12 points lower in afternoon trading. The S&P, after several sloppy sessions, is still up about 15 percent for the year and has moved mostly upward with no volatility.

The market’s strong performance is an important factor, since more weakness could encourage selling by investors looking to lock in double-digit gains before the end of the year.

“It’s November 15. The stock market is up 15 percent this year. The bond market is up 3 percent, and surely there are people out there who are looking at those sorts of numbers and saying, maybe I should rebalance, and maybe that has something to do with it,” said Ader.

Influential bond investor Bill Gross said on CNBC Wednesday that he does see a warning for stocks from the high-yield market, which is already about 3 to 4 percent off its peak even though the stock market is only 1 percent off of its peak.

“Usually the two move together,” he said. “I would look at the high yield market as an early indicator,” said Gross, who oversees the $2.1 billion Janus Henderson Global Unconstrained Bond Fund.

Events the markets are watching closely are the tax bill, on which the House will vote on Thursday, and the Dec. 8 spending resolution, which traders fear could cause another battle in Congress.

Traders have been watching the action in iShares iBoxx High Yield Corporate Debt ETF, HYG and SPDR Bloomberg Barclays High Yield ETF, JNK. The JNK ETF was down about 2.3 percent this month so far, but the moves in the high yield market are much greater in some sectors than others. Data from Strategas shows spreads widened most in telecom and health care.

Some of the broader weakness in high yield comes directly from concerns that the proposed tax bills in the House and Senate both include limits on the deduction of interest on corporate debt.

“For the whole U.S. high yield market, we’re talking about an incremental $8 billion of incremental tax that’s coming exclusively from the Senate proposal,” said Oleg Melentyev, high yield strategist at Bank of America Merrill Lynch.

Such a limit could cramp the financing options available to some companies. “The bottom 20 to 25 percent of market issuers will face hard choices in terms of how they’re going to de-lever in the new environment if this becomes law,” he said.

Melentyev said he does not currently see the sell off in high yield as a major signal for markets, and it’s basically been within a normal range so far. He said the selling centered in telecom after Sprint’s deal with T-Mobile fell through and after the Department of Justice had objections to AT&T’s acquisition of with Time Warner.

“My opinion is at this point, that equities are more dependent on this tax reform happening and basically the promises being delivered,” said Melentyev. “I don’t necessarily think the high yield market would react too negatively if this whole tax deal falls apart. Equities are more vulnerable.”

Larry McDonald, head of U.S. macro strategies at ACG Analytics, said the tax bill could actually be positive for high-yield because fewer bonds will be issued if the proposals go through, but it could also hurt financing options for some companies.

McDonald said he is paying close attention to the Chinese debt markets, where investors have feared a round of deleveraging. He said in that market the yield curve, between the 5-year and 10-year has already inverted, and markets were spooked when the 10-year yieldwent above 4 percent this week.

McDonald said his own 21 Lehman systemic risk indicators, which he designed to signal pending problems in financial markets, is rising at the fastest pace of the year. It is now back to a level where it was at just before the election, and at the time of the U.K. Brexit vote. “In both those times, we lost five or six percent. With the election, we lost five or six percent and then there was a vicious rally,” he said. While it’s not significantly elevated, more than 60 percent of his indicators are credit related.

source:-.cnbc