High-yield bonds flash warning that the stock market might break lower and retest its January bottom

A key leading indicator of bearish stock market action is flashing warning signals, according to a Wednesday note from Bank of America.

The high-yield bond index is starting to break down, which has historically been a reliable predictor of a stock market downturn, according to the bank. The bearish technical action in high-yield bonds suggests the S&P 500 could test and break below its January low of around 4200 later this year.

“This week we show bearish breaks for the iBoxx USD Liquid Investment Grade Index and iBoxx USD Liquid High Yield Index that are a potential bearish leading indicator for a break below 4200 area support on the S&P 500,” the bank explained.

That represents downside potential of at least 8% from current levels, and would signal that rising inflation, surging commodity prices, and the anticipation of higher interest rates could be holding back the economy.

In addition to the bearish breakdown in high-yield bonds, option-adjusted spreads of the high-yield bond index have formed a base and are pushing higher, which is another ominous risk-off sign that the credit markets are bracing for volatility that could ultimately spill over into the stock market.

If the S&P 500 is unable to hold support around 4200, more downside is likely to the 3800-4000 range, according to the bank, representing a potential drop of up to 17% from current levels. That would line up with BofA’s observation that midterm election years see an average correction of 20%.

Not helping stocks is a decline in FINRA margin debt from record highs over the past two months, which could hold back demand for equities.

“With signs of a maturing credit cycle and deleveraging, along with expectations that the FOMC will raise interest rates, investors may prefer to hold cash instead of relatively more expensive [margin] debt… We view this as a market risk for 2022,” BofA explained.

Bank of America