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Weakness In High Yield Bond Signals More Volatility Ahead for The Stock Market

High yield bond (also called junk bond) is often used as a risk-on or risk-off sentiment indicator. However, as high yield bond is very sensitive to the market liquidity, it is a reliable indicator to give early warning of the potential liquidity problem in the stock market.

Refer to the chart below to find out how the high yield bond (HYG) behaves when there are tapering of the bond buying program and quantitative tightening by the Federal Reserve (Fed).

Divergence between High Yield Bond and S&P 500

As shown in the chart below, divergence (highlighted in orange arrow) between high yield bond (HYG) and S&P 500 (SPX) showed up in 2014-2015, 2017-2018 and 2021 where S&P 500 formed higher highs while HYG formed flattened highs.

Pullbacks (highlighted in pink) with relatively large magnitude were seen when HYG struggled to go up to catch up with S&P 500. The divergence together with the meaningful pullbacks in HYG signaled the red flags in the S&P 500. Subsequently, S&P 500 experienced a 12% correction off the peak in 2015, 2018, and 2022.

In 2014 the Fed’s taper of the monthly bond-buying program responding to the global financial crisis in 2008, ran from January until October 2014, lasted 10 months. In 2018, the Fed conducted quantitative tightening in order to shrink its balance sheet.

Both the tightening of the monetary policy by the Fed caused the market correction of more than 10% with increasing of volatility as reflected in the trading range formed in the S&P 500 in 2015-2016 and 2018-2019.

Now, apart from tapering the bond-buying program scheduled to end in March 2022, the Fed is also considering quantitative tightening to shrink the balance sheet. On top of that. a rate hike is likely to happen in March 2022.

The fast pace of tapering, tightening, and raising rates are expected to stir up more volatility in the stock market, which is currently unfolding where S&P 500 just had a steep correction in January 2022.

Prior to the sharp correction in S&P 500, high yield bond (HYG) already gave early warning by producing multiple meaningful pullbacks on top of the divergence with the S&P 500.

In the past 3 weeks, despite the market rebounded off the oversold condition, the sell-off in high yield bond (HYG) continued, which could point to more weakness ahead in S&P 500. In order to better predict the short-term trend of S&P 500, Wyckoff method is adopted for detail analysis below.

S&P 500 Price Prediction with Wyckoff Method

Based on the Wyckoff phase analysis, S&P 500 had a selling climax (SC) in 24 January followed by an automatic rally (AR), which is a technical rally after an oversold condition. 4550-4600 (as highlighted in red) is the resistance area where the previous breakdown happened, which is an important level to overcome for a bullish up swing. Refer to the chart below:

Last week there was an attempt to breakout from the resistance zone at 4550-4600 yet failed with two bearish bars with increasing of volume, suggested presence of supply.

Increasing of volatility on both directions is one of the key characteristics of a bear rally. The bear rally as reflected in the automatic rally (AR) inflicted pain for the short-sellers to cover their short positions while lured in the traders and investors who were hoping for a V-shape rebound. Refer to the market outlook video to find out how to interpret the supply and demand in the volume together with the price action to better anticipate the movement in S&P 500.

Last Friday the bearish bar broke below the intermediate support level at 4450 suggested a test of the low formed by the selling climax as a secondary test (ST). So far, S&P 500 is still in a trading range between 4250-4600. Meanwhile, oil related stocks still outperform where there are many valid low risk trade entry setups with decent reward to risk ratio thanks to the strong crude oil price. Upside follow through is likely to continue for the oil stocks. Visit TradePrecise.com to get more market insights in email for free.

This article was originally posted on FX Empire


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