Investment Grade Credit Risk Vs. Buybacks

Investment grade credit spreads are a leading indicator for buybacks. Buybacks are correlated with the stock market.

A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. For example, if the 10-year Treasury note is trading at a yield of 2% and a 10-year corporate bond is trading at a yield of 4%, the corporate bond is said to offer a 200-basis-point spread over the Treasury.

As credit spreads rise, it gets more and more difficult to finance buybacks (credit conditions are worsening). Yields on corporate bonds go up (which coincides with a credit spread rise), which means that debt issued by the company (to buy back its own shares) has a higher interest rate. The result is that there will be less buybacks. There is a lag of 3 months (we borrow and then we spend).

Investment Grade Credit Spread Vs Buybacks

As buybacks are correlated with a rise in the stock market, we can assume that higher credit spreads are a leading indicator for lower equity markets with a lag of about 3 months.

So you could have predicted black monday in August 2015 (red graph) by looking at the rising credit spreads (blue graph).

//research.stlouisfed.org/fred2/graph/graph-landing.php?g=1YIr

Correlation: Carry trade Vs. Stocks

A carry trade can occur when a currency A is borrowed to buy another currency B. That other currency can be used to buy assets like equities (or short gold).

There are two prerequisites to have a profitable carry trade.
One, the currency A needs to depreciate against the other currency B.
Two, the yield on the other currency B must be higher than the carry traded currency A.

A famous carry trade is the yen carry trade where yen are borrowed to buy U.S. dollars. We have seen this during the housing bubble from 2003 to 2007 where yield spreads were very high (see chart below) and we are seeing this happening again today in 2013-2015 where we have again a stock bubble.

Whenever this yield spread narrows again, the probability of a crash increases. I see this carry trade yield spread as a leading indicator for the stock market.

//research.stlouisfed.org/fred2/graph/graph-landing.php?g=Q2X

Predicting the Recession via Narrowing Yield Spread

There is a nice metric to predict a recession of which I talked here.

Basically when the 10 year yield to 3 month T Bill yield spread narrows, you’re probably nearing a recession.

This is the status today. Nothing much happening today, but we will see below that something is starting to happen. See chart below from Nowandfutures.com.

And in more detail:

Go here to read the analysis.

Correlation: Recession Vs. Yield Spread

I came across an interesting article that gives an empirical correlation between the yield spread between the 10 year and 3 month treasuries/bill and the probability of a recession when that yield spread narrows.

The key is to monitor that the 10 year yield is always higher than the 3 month yield. If the 10 year yield starts to go closer to the 3 month yield and even goes below it, then we have a high probability of a recession.

That correlation can be witnessed on chart 1. Each time the blue line goes below zero, we have a recession.

Chart 1: Recession Vs. Yield Spread

The last recession was in 2008. A few years before, the yield spread went to zero. Today we’re in pretty safe territory (Chart 2). The green line minus the black line is 2%. If we see the black line go up again or the green line go down, we are in trouble. That’s why the Federal Reserve never will increase the fed funds rate. Otherwise the black line will spike upwards.

No problems today. But it pays off to watch the yield spread each month or so.

Chart 2: U.S. bond yields

This theory is applicable to every country. I analyzed Spain for example in this article. 

Chart 3: Spanish Bond Yields (10 year vs 2 year)