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When Silicon Valley Bank became the second largest bank failure in U.S. history, fears surged that a calamity would hit the financial markets.

Other regional bank stocks tanked, and a “flight to quality” sent safe-haven assets like gold and U.S. Treasuries soaring.

But you shouldn’t jump to conclusions until you check out one key market sector – and that is with high yield bonds (which are often referred to as junk bonds).

If a broader economic and stock market meltdown is underway, it will be confirmed by this often-overlooked corner of the market.

That’s because high yield investors are a very discerning bunch. They already know the companies they’re lending to are on shaky financial ground. And that makes them very sensitive to changes in the economic outlook… for better or worse.

Here’s how to use the junk bond sector to know whether the disaster in the banking sector will spread to the rest of the market.

High Yield Signals the Outlook

As the name suggests, high yield bonds are issued with a higher interest rate compared to a safer bond, like a U.S. Treasury security. The difference between the rates is called a spread.

That higher interest rate is additional compensation for investors. This is because companies issuing high yield debt have lower quality balance sheets or are struggling to generate enough income to make debt payments.

In other words, there’s a larger chance that the issuing company would default on interest payments should the economy sour.

And that’s why tracking high yield spreads is a useful indicator for the economic outlook.

A growing spread over a safer investment indicates investors are demanding extra returns to lend to low-quality companies. When spreads are rising across the high yield sector, that reflects concerns on the broader economy.

That works the other way around too. When spreads move lower, that’s a sign investors expect better days ahead and aren’t as worried about getting their money back from higher risk companies.

So as the debacle in the banking sector unfolds, I’m closely tracking high yield spreads to see if there’s broader spillover risk to the economy and stock market.

Here’s what spreads are saying now…

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Watch this Chart

After widening in the first half of 2022, high yields spread have been slowly working their way lower. And in the process, spreads are creating a key chart pattern to track.

Below, you can see the chart of spreads going back a couple years. I’ve highlighted the pattern with the red dashed trendlines, which in chart jargon is called a “descending triangle.”

A breakout will be very revealing for the economy and stock market.

A break above the upper trendline with rising spreads would signal fears that the current banking crisis will spread to the broader economy.

We saw spreads trade above that level on Monday, and I expect more downside in stock prices if spreads continue moving higher.

But a reversal below the lower trendline would signal the “all clear,” and that the woes plaguing the bank sector won’t turn into a full-blown financial crisis.

In the coming days, we should expect plenty of volatility as the situation in banks unfolds. But if we closely track high yield spreads, we can stay one step ahead of where the economy and stocks will head.

Best regards,

Clint Brewer
Analyst, Market Minute

P.S. To see the 10 stocks that are on Jeff Clark’s radar this earnings season, make sure to tune into his FREE whiteboard session at 9 a.m. ET.

Reader Mailbag

What other sectors do you look to for signals on where the broader stock market will head?

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