Tightening credit conditions could mean bad news for the stock market. The credit spread, which is basically the difference between yields with the same maturities but varying quality, is widening. The 10-year Treasury yield has fallen since last month and the 10-year BBB corporate bond yield has been on a slight climb.
And while its not at worrying levels yet, investors should be on the lookout — CLSA investment strategist Damien Kestel sees it as the “biggest risk” to the stock market.
That’s partly because a large gap between the two yields can signal that credit conditions, which are widely seen as an indicator of risk appetite, are tightening. And with more hawkish monetary policy on deck, those conditions could get worse.
“The continuation of quantitative tightening in America, along with the projected Fed rate hikes, represents the biggest risk to still presumably Wall Street-correlated world stock markets,” Kestel added. “Credit spreads should now be watched closely.”
CLSA
A widening credit spread has historically not played out well. By late 2008, a few months into the financial crisis, it had spiked more than 400 basis points to nearly 7%. While the spread is nowhere near that right now, at about 1.30%, Jack Ablin of Cresset Wealth warns that further widening is cause for concern.
“While credit conditions are favorable today, spreads have widened in recent weeks and are currently situated just below their 200-day moving average,” he noted. “Continued widening would be a risk-off signal.”
That could very well happen, according to analysts at Morgan Stanley, based on increased funding stresses, weaker trading liquidity and higher volatility.
“This is arguably what quantitative tightening feels like and, in our view, these dynamics will continue to pressure credit spreads over the course of the year,” analysts at Morgan Stanley said.
Published in Daily Times, April 16th 2018.