A U.S. options strategist has raised concerns about possible declines in equity markets over the next three months. This warning stems from current trends in the credit market. Right now, credit spreads are very narrow, meaning that corporate bond investors are settling for smaller additional yields compared to government bonds. Narrow credit spreads can indicate optimism, but this may not align with the current economic situation. Asset managers are wary and are reducing their investments in high-yield credit because of fears of slower growth and higher default rates. Historically, shifts in credit indicators, like CDX and iTraxx, often precede stock market volatility.

Credit Market Benchmarks

The ICE BofA U.S. High Yield and Corporate Option-Adjusted Spreads, which can be viewed on the Federal Reserve Economic Data site, serve as useful benchmarks. An increase in spreads usually signals a decrease in risk appetite and potential market stress. Investors are also keeping an eye on inflation reports that affect interest rate expectations, which, in turn, influence bond yields and spreads. It’s important to track credit spreads and inflation figures because discrepancies between stock prices and credit spreads can highlight market weaknesses. By observing movements in credit spreads and understanding indices like CDX and iTraxx, investors can identify early warning signs in credit markets and better evaluate risks in their investment portfolios. Credit markets are hinting at possible challenges for stocks in the near future, so it’s wise to stay alert. Corporate bond investors are currently accepting very low extra yields, indicating optimism that may not be warranted. This narrowness in credit spreads could make the market vulnerable if economic growth slows. At present, the ICE BofA high-yield spread is just 305 basis points, reminiscent of the complacency seen in late 2021 before the rate hikes of 2022. Meanwhile, the CDX Investment Grade index sits close to 50 basis points, while the S&P 500 exceeds 6,200. This disconnect—where credit markets are stretched thin but stock prices are high—often leads to significant corrections.

Strategies for Navigating Volatility

This situation warns derivative traders about potential volatility, especially since the VIX index is around a low of 13. Equity options seem to be undervaluing the risks signaled by the credit market. A similar trend happened before the downturn in early 2022 when credit spreads started widening weeks before a major drop in the equity market. The U.S. inflation report due tomorrow, August 12th, will be crucial to watch. If the number exceeds the expected 2.8% year-over-year, it could quickly widen spreads and likely increase equity volatility. Given this risk, now could be a good time to buy downside protection. Purchasing out-of-the-money put options on the SPX or QQQ with September or October expirations can effectively hedge a long portfolio. The current low volatility makes these options relatively inexpensive. Another option is to directly consider volatility through VIX derivatives. With market anxiety so low, buying VIX call options for the coming weeks may provide a cost-effective strategy for a sudden market shock. If credit spreads start to widen, the VIX would likely be the first to react. It’s essential to monitor key credit benchmarks, like the high-yield option-adjusted spread on FRED, every day. If equities rise after the inflation report but credit spreads do not tighten to support this move, that rally may be unstable. This would suggest it’s time to consider bearish call spreads. Create your live VT Markets account and start trading now.

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