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A VIX Curve Theory: Charts Say Last Week's Swoon Has Further to Go

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Plus: Here's why higher yields are likely to bring out even more corporate bond buyers.

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Last week the broad media began discussing in panicky terms the recent increase in interest rates. Specifically they noted how closed-end funds and ETFs like the SPDR Barclays High Yield Bond Fund (NYSEARCA:JNK) had taken some serious price hits. Unfortunately, in my humble opinion, that completely misses the point of what is actually going on.

The corporate bond market is critical to equities because companies sell bonds and then use those proceeds to buy back their stocks. So what we need to focus on first and foremost is the appetite of buyers for new corporate issues. Through those lenses, the $167 billion of new bonds sold just in the month of May suggests that that dynamic is not only alive and well, but given the level of low yields buyers were willing to accept, the pace of demand was simply unsustainable. So rather than fret over somewhat higher interest rates, I would argue that higher yields are likely to bring out even more buyers, and potentially accelerate the rate of new bond sales and the eventual stock buybacks. The drop in instruments such as the JNK ETF is irrelevant to this process since it measures the prices of bonds that are already in circulation and not the demand for new bonds.

Furthermore, as I showed last week on the Buzz & Banter (subscription required), the recent increase in high yields is almost unnoticeable on the weekly chart. Yes, high yield rates have risen some 80 basis points from the recent lows, but at least half of that is attributable to the increase in Treasury rates. So the rise in the risk-premium of high yield bonds is borderline irrelevant. I am not dismissing, and in fact I have written, that spiking yields would spook the stock market, but to monitor the true health of corporate bonds (or factors that may impact it), watch things such as the credit default swaps of our large financial institutions, the credit default swaps of weak foreign countries, the 2-year swap spreads, and the CDS on US debt.

Switching gears on how deep an equity markets correction may be (if one has finally started), a lot of focus is being put on the Volatility Index (INDEXCBOE:VIX). I watch it as much as the next person, but the shape of the VIX curve (I use the index versus the 3-month futures) seems far more telling than the index outright. In fact, with one noticeable exception which I will deal with in a second, every time the curve has inverted it marked just about the lows for stocks. Aside from the mechanical aspects of this indicator, it also makes intuitive sense. A steep VIX curve suggests that people are complacent about impending risk, even though they may be convinced that doom lurks just around the corner. On the other hand, an inverted VIX curve tells us that investors are scared right here and right now, a condition that often coincides with good market lows.



The chart of the S&P 500 (INDEXSP:.INX) and the VIX curve shows one notable exception to the above approach. In the summer of 2011 the curve inverted and remained so for an extended period of time, while the SPX was hammered for more than 20%. At risk of trying to rationalize why my VIX-curve argument failed that time, I will note that in 2011 the VIX curve inverted while the VIX index was already at a very high level of about 25. That suggests that fear was already in the market even before equity prices began reflecting the European credit dislocations that would follow.



Also, looking at a chart of the VIX with the 50, 100, and 200 daily moving averages, you can tell that over the last three years every time the 50 DMA crossed above the 100 DMA, the VIX spiked significantly higher shortly thereafter. Such a crossover occurred last Thursday, and to these eyes it raises the probability that Friday's stock swoon may have further to go.



In summary, despite the likelihood (inevitability?) that at some point stocks will correct for more than just a few hours, with the backdrop of the current state of the corporate bond market, it's important to keep in mind that the sharpest corrections tend to occur in primary bull moves.

Twitter: @FZucchi
Position in SPY
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