Studying the Credit Markets of 2008 for Clues on 2020

A Dislocation in the Bond ETFs

It’s raining money so today we will cover a couple of bond ETFs, the credit markets and the Fed. In particular, I will highlight the current dislocation in the credit markets using the 20+ Yr Treasury Bond ETF and the Corporate Bond ETF. We will then look at credit spreads and note that these spreads often peak ahead of a stock market bottom. And finally, I will finish with the Fed’s balance sheet as it hits a record, at least for this week. The 2008 financial crisis is still the current blueprint going forward and suggests that the stock market needs a few months to find its feet.

A serious dislocation in the credit markets created a volatility spike in dozens of bond ETFs, including the 20+ Yr Treasury Bond ETF (TLT) and 7-10 Yr Treasury Bond ETF (IEF), which are the ultimate safe havens. The 22-day Average True Range (ATR) surged to its highest level ever (by far) for both ETFs. Over the last 18 years, 22-day ATR never came close to 1 for IEF and exceeded 1.5 last week. 22-day ATR never exceeded 2.5 for TLT and surged above 5. The chart below shows ATR and the 22-day Standard Deviation.

ATR and the Standard Deviation of price are not ideal measures for volatility because you cannot compare values against other names. Compare $SPX to SPY for an example. Instead, we should use a normalized version of ATR or the standard deviation of price changes. The chart below shows annualized volatility based on price changes and this historical volatility measure spiked to its highest level ever for TLT (> 70%)

The chart above was created with Optuma.

I will update the Index and Sector Breadth Models in Saturday's commentary - and also provide a video.

Corporate Bonds Feel the Heat

This volatility spike was even greater outside of the Treasury bond safe-havens. The Mortgage Real Estate ETF (REM), Corporate Bond ETF (LQD), Aggregate Bond ETF (AGG) and Muni Bond ETF (MUB) also plunged from March 9th to March 19th. Everything rebounded over the last few days, but the degree of rebound varies significantly. The chart below shows annualized volatility spiking above 50% for LQD. Note, however, that the October 2008 spike marked the low and LQD bottomed five months ahead of the S&P 500.

I am not ready to call for a bottom in the bond market, but the Fed is buying up all kinds of stuff and could stabilize the credit markets. Personally, I am watching the credit markets and credit spreads for clues on the stock market going forward. Improvements in the high-yield and BBB corporate bond spreads would be positive.

Bear Market Projects

As part of the goal to “up my game” during the bear market, I am using Optuma software for charting and quantitative analysis. I will continue to use StockCharts for basic charts, but will turn to Optuma for specific data sets (FRED) and indicators (annualized volatility).

Bubble is Spelled with three B's

As Bruce Richards of Marathon Asset Management notes in this Bloomberg video, the bond vigilantes threw out the baby with the bath water last week and created some great opportunities for specialists in distressed debt. However, the effects of this dislocation could be felt for a while and there are many pockets to avoid (energy, hospitality, cruise ships).

Anyone interested in broad bond ETFs (AGG), mortgage REIT ETFs (REM), Mortgage Backed Securities ETFs (MBB), corporate bond ETFs (VCIT) or emerging market bond ETFs (EMB) best study up and investigate the holdings before taking a position. The devil is in the details and the holdings. I would also throw REITs into this group.

Richards suggests spelling bubble with three B’s because the BBB market place went from 700 billion in 2008 to 3.4 trillion dollars now. BBB is the level just above junk and accounts for 47% of LQD. He thinks 10% of BBB bonds will fall into the junk category and default rates will hit 10%. It will be a great time for distressed debt specialists who can pick and choose, but a rough time for many broad-based corporate bond ETFs.

The chart below shows the yield spread between AAA bonds and Treasuries, and between BBB bonds and Treasuries. AAA bonds are the highest rated investment grade corporate bonds, while BBB bonds are on the lowest rung for investment grade bonds. AAA bonds yield 1.58% more than Treasuries, while BBB bonds yield 4.5% above Treasuries. We are nowhere near the 2008 peaks, but spreads are still elevated and this reflects risk in the credit markets. A move back below the red lines would signal a return to normalcy.

Junk Bond Spread Hits Double Digits

The next chart shows the yield spread between Corporate Bonds and Treasuries, and Junk Bonds and Treasuries. Both of these shot up last week and remain elevated. Junk Bonds yield 10% more than Treasuries and this is the biggest spread since 2009. Notice how these two spreads peaked in December 2008, at least two months ahead of the stock market bottom in March 2009. Again, I will be watching the red lines for signs that the credit markets are moving back to normalcy.

Bruce Richards, who was mentioned above, is not a raging bear and he does expect the markets to rebound once covid-19 is under control. Keep in mind that he buys distressed debt. I would also guess that he is looking 6 to 12 months out.

These data sets are available at the St. Louis Fed website (FRED). The FRED symbols are shown as the watermarks on the charts. I linked the two charts to one of the data series at FRED and you can also view the charts there.

To Infinity and Beyond

Since we are dealing with the Fed, I may as well update the balance sheet, which expanded by over $1 trillion over the last five weeks. Thus, we have a 2 trillion dollar fiscal stimulus and a 1.1 trillion dollar Fed injection battling the bears right now. These numbers will likely grow in the coming weeks. As the chart below shows, Fed assets are now at their highest level ever. Actually, this is not the highest level ever because there will be a new high next week.

The chart above shows the asset expansion in October 2008 when the size of the balance sheet doubled. This was also an increase of over $1 trillion. The stock market bottomed around 5 months later. Thus, Fed action saves the credit markets (bonds) and fiscal action helps the economy (stock market). I would like to see the credit market stabilize before getting excited about a bottom in stocks. Thus, it could still be a rocky ride the next 3 or so months.

The stock market is living up to the October 2008 scenario and high volatility is expected for a while. SPY gained over 5% on Thursday and then opened 3% lower on Friday morning. Maybe it will rebound, maybe it won't. One thing is for sure: this is no market for weak stomachs.

Thanks for tuning in and stay safe!

-Arthur Hill, CMT
Choose a Strategy, Develop a Plan and Follow a Process

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