As the volatility of the week starts to shake out, it is important to focus on empirical data versus emotions. The question on everyone’s mind is whether this was a routine pullback or the start of something more concerning. While no single indicator can provide a definitive answer, it’s essential to take a mosaic approach to data to weigh the evidence.
One particularly interesting data point is the high yield bond spread. You may often hear that spreads are “widening” or “narrowing”, but what does that mean? Simply put, the spread measures the difference in yields between bonds and the risk-free rate, typically a comparable government bond. This metric normalizes bonds, putting them on equal footing and helps investors identify which bonds offer the best risk-adjusted returns.
Typically, when spreads increase it indicates rising credit risk, interest rate risk, and economic uncertainty. Since late 2022, credit spreads have been steadily heading lower, which is generally positive for equities. However, this month marks an increase in spreads. Is this an indication of a shift towards a risk-off environment, or is it just a brief move higher in the overall downward trend? Time will tell, but generally, higher spreads can lead to lower forward equity prices.
