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Canary In The Coalmine?

Canary In The Coalmine?

July 14, 2021
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To state the obvious, coal mining is a dangerous occupation. Not only do coal miners have to deal with collapsing tunnels and explosions, they also have to deal with the potential for dangerous carbon monoxide fumes. Crafty folks that (obviously) wanted to stay alive, coal miners would bring canaries with them into the mines to help sniff out the dangerous fumes. Canaries, apparently, are much more sensitive to the odorless fumes so if miners saw the birds becoming distressed, it would serve as a warning sign that carbon monoxide fumes were likely prevalent and they should reverse course.

Within the fixed income markets, the high yield credit market can, at times, act like a canary in the economic coalmine. The return distribution for high yield investors is asymmetrical, which means the potential for losses can be magnitudes larger than the potential for gains. So, credit markets tend to react quickly when economic conditions start to deteriorate.

“Rarely does the price action in one market tell the entire story,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “When we take a more holistic look at markets though, we aren’t seeing broad economic weakness on the horizon. But we are continuing to pay attention to those market signals.”

The 10-year Treasury Yield’s fall of over 40 basis points (.40%) from March highs has left many investors asking if the bond market is telling us something we don’t know about the durability of the economic recovery. We don’t think so. As seen in the LPL Research Chart of the Day, historically, when Treasury yields have decreased because of economic slowdowns or some broader risk-off/macro event, credit spreads have increased—sometimes dramatically. If the Treasury markets were signaling a significant slowdown in growth, the credit markets would be showing something similar. Treasury yields and credit spreads tend to move in opposite directions, so the absence of a negative signal from credit markets gives us some comfort that the move lower in rates has been mostly technically driven.

See enlarged chart.

Positioning within fixed income has been pretty bearish- meaning investors have implemented strategies that work if interest rates increase. Over the past few weeks though, we have seen investors reverse course and close out some of these bearish positions, which perversely has likely caused interest rates to move even lower.

Additionally, even at 1.38%, U.S. interest rates are attractive to foreign investors when their home currency bonds are yielding near zero or even negative. With Japanese government bonds yielding 2 basis points (.02%) and German Bunds yielding -31 basis points (-.32%), we’ve seen a lot of foreign interest in U.S. Treasury markets, which has also helped push yields lower.

These technical pressures on yields are independent of the fundamental story, which suggests the economy continues to grow strongly. We are certainly paying attention to the price action in the Treasury markets but we don’t think it is signaling concerns that negative events are on the horizon.

 

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This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change. References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy. All index and market data from FactSet and MarketWatch. This Research material was prepared by LPL Financial, LLC. Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC). Insurance products are offered through LPL or its licensed affiliates.  To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.

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