If bonds are right, a steep equity correction is underway

2017 has seen many hedge fund and portfolio managers send warning signals that an equity market correction is overdue.

Overstretched valuations, tighter monetary policies, geopolitical risks, a slowdown and high debt levels in China and low inflation, are some of the factors that could potentially trigger a market correction. However, all of these warnings are being ignored, and stocks continue to score new highs.

“Buy the dip” mentality has been in play throughout the year, especially because many investors don’t want to miss the opportunity of a potential rally when the U.S. lowers the corporate tax rate, however the sharp differences between the House and the Senate suggest there are still many barriers to overcome.

When investors start feeling nervous, volatility tends to spike and a shift is realized from high-risk assets to safer investments. The CBOE’s Volatility Index (VIX) although having appreciated 25% the past six trading days, it is still trading at 11 which isn’t a sign of serious nervousness. The S&P also declined in the past week but it is still 0.5% away from its record high; this is another indicator that investors are not worried. However, bond markets are sending a totally different signal.

Junk bonds or high yield bonds are a proxy to risk, and the correlation between junk bonds and equities tends to be too close. ETF’s such as iShares iBoxx High Yield Corporate Bond and SPDR Bloomberg Barclays High Yield Bond, have both fallen to an eight-month low; meanwhile equity investors remain complacent. With divergence now apparent, the question to be asked is who’s right? The bonds or equities markets?

Emerging bond markets are also providing similar signals, diverging from equity performance, and I am certain that such a negative correlation may not last for long. Even the U.S. Treasury yield curve has flattened the most since 2007. The spread between U.S. 2-year note yields and 10-year notes declined to 67 basis points last week. No doubt expectations of tighter U.S. monetary policy, ECB’s bond-buying program, debt issuance and supply and demand, were all factors that influenced the shape of the U.S. yield curve, but the longer this trend continues, the more worried investors should become. A flattening yield curve is an early sign of a recession or at least an economic slowdown – that shouldn’t be ignored. If the yield curve inverted, then bond markets will be screaming “SELL”.