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U.S. Bond Market: The Look Of Fear... and Failure
To borrow from one of the most famous quotations of all time: The only thing the U.S. economy has to fear is fear itself. Anxiety is to a rising market what a flaming torch is to a hot-air balloon. The challenge comes in recognizing when things are about to go “POP!”
Now, there is no perfect way to quantify human behavior. Yet we also know that fear can and does drive markets -- so the question is: How does one measure emotion?
In our experience, one of the most reliable measures of collective investor emotion is the Junk-to-Treasury Yield Spread, or difference between low grade and high-grade debt. A trend in either direction has the following implications:
- Narrowing yield spread: The public takes greater risks in search of greater rewards. Feelings of optimism encourage speculation and spending, the two engines of economic growth. Stock markets usually rise.
- A widening spread: The public flees to safe assets. Feelings of pessimism dissuade risk-taking in any form. Stock markets usually fall.
So, major trend changes in the Yield Spread is indeed a reliable measure of investor sentiment. And that's exactly what the September 2007 Elliott Wave Financial Forecast (EWFF) explained, when our analysts presented a bold snapshot of the spread between the yield on the US Industrial B-rated 10-year Bond AND the 10-year US Treasury Bond.
At that time the market was early in a widening trend that had begun in June 2007. In EWFF’s own words: “Lehman, Bank of America, Barclays Say Rout Is Over.” We say: “It’s Just Beginning.”
A year later, the June 2008 Elliott Wave Financial Forecast revisited that same chart and picked up where it left off. Below is an exact reprint: Keep scrolling down, a little bit further, still further. O.K. Now… … … Stop.
(Editor’s Note: The most dramatic upsurge in the yield spread occurred right as the Dow Jones Industrial Average was nearing its October 9, 2007 all-time peak. Now, the August 2008 Elliott Wave Financial Forecast reveals where the spread, and stocks, are headed next. Learn More.)
In his 2002 bestselling book “Conquer The Crash,” Bob Prechter foresaw that --when the psychology of fear woke from its bullish slumber, it would find the following bedfellows:
“When the social mood trend changes from optimism to pessimism, creditors, debtors, producers, and consumers change their primary orientation from expansion to conservatism. When lending officers become afraid, they call in their loans and slow or stop their lending no matter how good their clients’ credit may be in actuality. Instead of seeing opportunity, they see danger.”
News Flash: This July, the Federal Housing Administration began taking credit scores into account and considering rates on a case-by-case basis for the first time since its establishment in 1934.
And, according to an August 4 news item, the U.S. government has the fewest bond traders making markets in its Treasuries since 1960. (Bloomberg)