ACTV - Widening Credit Spreads May Sink Stocks As Volatility Surges

2023-03-26 06:15:00 ET

Summary

• Financial conditions are beginning to tighten again.
• Tighter financial conditions are due to widening credit spreads.
• Widening credit spreads will increase implied volatility, and be a headwind for stocks.

In 2022, the equity market experienced a decline due to tightened financial conditions caused by the Fed's rate hikes and the strengthening of the dollar. However, in 2023, despite continued rate increases by the Fed, the dollar has stopped rising, and financial conditions have eased, leading to a loosening of financial conditions and a pause in the decline of stock prices.

Wider Spreads Means Tighter Financial Conditions

Unfortunately, the situation is becoming more complex, and a new layer of financial conditions is beginning to tighten. This is primarily due to wider credit spreads, as investors become increasingly concerned about bank deposit outflows and potential losses on held-to-maturity portfolios. Additionally, fears are emerging that lending standards will tighten, leading to further declines in stock prices.

Early signs of financial conditions tightening have been evident in the Chicago Fed's National Financial Conditions Index over the past week. Both the traditional and adjusted measures of the index have tightened, although they are still below their October peaks. However, the index will likely continue to tighten in the coming weeks.

The current form of tightening may be challenging to track and not as straightforward as the previous tightening cycle driven by rising rates and a strengthening dollar. It is possible that conditions could tighten even more if rates fall and the dollar weakens. The primary driver of tighter conditions will likely be the widening spreads between corporate and high-yield rates and Treasury rates.

Recently, a regime change has been reflected in the Markit CDX Investment Grade Index and the Markit CDX High Yield Index, both of which have shown sharp increases. The rise in these credit indices indicates a tightening of financial conditions through widening credit spreads.

Wider Spreads Means Higher Implied Volatility

The changes in credit spreads directly impact the equity market, as indicated by the rising and falling implied volatility levels. The VIX index ( VIX ) has historically been an excellent tracker of changes in credit spreads, and when spreads widen, it indicates that the VIX is likely to rise. The more credit spreads widen, the more likely the VIX index will also continue to increase. Rising implied volatility is a headwind for stocks, and the more the VIX rises, the more the S&P 500 is likely to fall.

According to data from Quant-Insight corporate credit has become the most significant contributing macro factor to the S&P 500 ( SP500 ), and it has passed the positive effect of slowing inflation rates.

One way to measure these spreads is by using the ratio of the iShares 1-3 Year Treasury Bond ETF ( SHY ) to the iShares iBoxx $ High Yield Corporate Bond ETF ( HYG ). Although this ratio is not an exact representation of the CDX High Yield Index, it closely tracks changes in these spreads and is an easy way for people without access to the CDX High Yield Index to track these changes.

Financial conditions are not as tight as in October, as they are still well below their previous highs. However, if the market has indeed undergone a repricing of risk due to recent events such as the fall of Silicon Valley and Credit Suisse, in that case, it seems highly likely that financial conditions will likely tighten even further. If this happens, it will be a significant challenge for stocks.

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