Junk in a Funk. Debt Deflation Looming?

This could be a sign of deteriorating sentiment.

One of the many head-shaking phenomena over the past eighteen months or so has been the fact that junk bonds have held in so well. I guess we shouldn’t have been that surprised though as the Fed has used its historic money counterfeiting scheme to effectively underwrite indebted corporates that would, under normal circumstances, have gone out of business. However, evidence is emerging that the junk bond market might be returning to planet earth.

The chart below shows the yield spread between junk bonds and U.S. Treasuries. Elliott Wave International last showed this chart in October and stated that:

“The spread hit its narrowest since 2007 in early July at 5.76%. From there, the spread sports a distinct 5-wave advance (indicating junk bond underperformance) to 6.66% in early August, followed by a sideways consolidation. From this set-up, we can say that there is a high probability that the junk bond yield spread is about to widen again and that there’s a good chance it will advance by close to 1%, possibly much more.”

It took its time, but the spread has now started to break above the sideways range, indicating that a potentially explosive upside move might be underway. Investment Grade corporate yield spreads have already been accelerating higher and so, perhaps, the penny is now dropping for holders of riskier debt that the great benefactor of the Eccles Building is putting its check book away. That “fundamental change” would be consistent with a third wave higher, which the spread might be entering.

If the junk bond market, and corporate debt in general, is deepening its already underperforming trend, it could be a sign that sentiment is deteriorating quite quickly now. That might be bad news for stock markets, and lead to credit downgrades and defaults. Corporates could be about to find out what debt deflation is all about.