The Yellow Brick Road

I’m just back from vacation and I’d like to publish something lite as a warm up, before I catch up with the news. I would like to make some trivial observations on the junk bond market.

This chart shows the junk bond market for 15 years (I don’t have a longer chart).

What can we see?

• While the relationship of stocks and treasuries is a complicated matter, with junk bonds it’s all easy - they are just correlated, both long and short term
• The 7 (?) year (1993-2000) green uptrend line was broken in 2000 and junks never fully recovered, despite the complacency of 2006 and the M&A boom
• During the last recession the chart painted a giant H&S pattern (1997 to 2001), represented by the blue line at the neckline
• This former neckline was tested multiple times from 2004 to 2007 and was rejected almost every time. That was a pretty bold warning that something bad is slowly brewing at the credit markets
• The red line represents a giant support line. While the stock market is still very far from the 2002 bottom,  junk bonds already made 2/3 of the trip from the top. If the bear market in stocks continues further (I bet it will), junk bonds are likely to break the red line

Let’s zoom in:

The giant support line was broken in January, then made a textbook retest of the line from below and was rejected. This must be very bearish. Good chartists can probably tell how bearish it is.

Now let’s look at the most precious thing we have in bonds - our treasuries:

• The blue trendline is broken in April
• The less aggressive red trendline broken in May and tested from below while I was on vacation
• The green resistance is unlikely to be broken

My opinion is that we are observing the next logical step of this credit crunch - the price of money is going up. When treasury yields are going up, everything will go up. For example - investment grade bonds:

While I was on vacation the index just broke 6.42% - the record since 2002. Multi-year records must not be taken lightly.

What does it all mean? My theory is that the economy is at the end of the giant credit cycle that started in 1949, i.e. Kondratyev Wave and we are in Winter, the phase when the credit is to be unwound. The initial stage of credit unwinding is manifested by universally high rates, as credit demand outweighs the supply. It doesn’t really matter what the Fed does. It is not in control here.

While the stock market is setting up a rally, the bonds are weighing in. It usually takes several weeks until the realities of the expensive credit bubble up into the dumb-heads of the stock traders, but when they do the ongoing uptrend will stop. What do I expect?

The Dow Jones just painted a giant H&S pattern. The neckline will be probably tested from below and then you can kiss the stock market and the economy goodbye!