While the stock market focused on the speech Friday by Federal Reserve Board chairman Jerome Powell (and was duly disappointed by his tamping down expectations for future rate cuts) and the US-China trade war, investors should also focus on other financial assets. In particular, a good question to ask is what does high yield bond market action, for example, mean for stocks? (For more on the Fed see page 6.)

What the Fed does or doesn’t do is a key input—and I’ll get to that in a moment—but I try to look at signals the market is ignoring, often at its own risk. This week the HY market is telling you something and investors should pay heed.

Stocks have not gained much ground in the past week, as lingering macroeconomic fears, interest rate mayhem and ongoing trade tensions, which exploded Friday, have kept the S&P 500 index below the 2,940 (the 50-day moving average). In the U.S. Treasury market, the inversion of the yield spread between the 10 year and two-year notes plus the relentless drop in interest rates have created high economic anxiety, not a formula known to instill confidence.

But here’s the challenge to bears. High-yield OaS (options-adjusted spreads) rallied a substantial ~40 basis points in the past week while the S&P 500 index finished just a bit lower over the same period. I tend to view the high-yield market as “leading” equities and is hence a positive.

HY Stages Quiet Rally; VIX Term Structure Normalizes
Source: FS Insight, Bloomberg

It often pays to look at history. At the chart below, notice what happened to high-yield bonds during the 2000 and 2007 stock market tops? While equities were posting new highs, HY was weak. In other words, HY markets, often considered an equity like asset, were not confirming the stock market highs posted in 2000 and 2007. Instead, HY spreads were blowing out big time and basically “calling” the market tops in those years. This is a major difference versus today.

Another positive development is the normalization of the VIX term structure, where the 4-month VIX futures contract is now above the 1-month. When this is inverted, I view this as a sign of extreme fear, and that was the case from Aug. 5 to Aug.19. This past week it normalized. As I’ve noted previously, normalization sees an average stock market gain of 9% in next six months.

HY Stages Quiet Rally; VIX Term Structure Normalizes
Source: FS Insight, Bloomberg

Another thing global markets remain fixated on is the US Treasury 10-year-two-year yield curve, which continues to vacillate between inversion and normal. Granted, investors need to respect this signal, suggesting elevated risk of recession within the next 2 years. However, this does not mean to avoid stocks for next 17-20 months. In doing so, you could miss big gains.

Five out of five times that the 10yr-2yr inverted, the S&P 500 subsequently staged new all-time highs, averaging 33% in past 3 inversions.

And here’s a curiosity: Why is the U.S. the only real 10-yr-2 yr inversion? The only other is Hong Kong, which is understandable, given the serious political protests. The salient point is that if trade wars truly are creating a cyclical risk, then it would global, given the importance of the U.S. economy in the world. Why are there no inversions in Asia or Europe? One would expect that. This strengthens arguments for other, nonfundamental factors, like convexity hedging, causing US long-term rates to plunge (thus, creating inversion).

Moreover, the U.S. has the highest yield among large, developed nations—many of which have negative yields—and that also attracts bond buying, depressing the U.S. yields further. (See nearby chart.)

Now, let’s talk about the Fed. I think the Fed, despite what Powell said Friday, probably has to cut another 75 bps before yearend. The entire term structure of US Treasury rates is below Fed funds currently. And only 75bp would bring Fed funds rate below the lowest rate (5-yr note).

What could go wrong? Powell could confuse markets with a mix of hawk-dove speak. It’s happened before and this has been a chronic issue. And then there are all those macro factors I outlined at the top of this note.

Bottom line: I believe a risk-on rally has been further “green-lighted” by the HY rally and by the VIX term structure normalization. I continue to see a 2H19 rally, supported by a recovery in economic momentum as destocking runs its course and by the stimulative effect of lower rates, and, I hope, by a trade resolution.

The following 24 stocks have lagged where the HY/IG bond outperformed Treasuries, so the stocks should catch up: GM, KSS, DRI, RTN, CAT, CMI, EMR, ROK, CSCO, GLW, IBM, INTC, MSFT, HPQ, NEM, NUE, COP, PSX, VLO, STT, COF, CAH, HUM and PFE.

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