High-yield bonds (a.k.a. junk bonds) are a great gauge for investors’ willingness to take on risk.

That’s why Jeff Clark says that a move in junk bonds is often a leading indicator for the stock market.

If stocks are set to move higher, junk bonds will usually rally first. The same thing happens the other way around. A fall in junk bonds often precedes a sell-off in stocks.

That’s why what’s happening in the junk bond market right now is so fascinating…

Junk bonds, as measured by the iShares iBoxx High Yield Corporate Bond Fund (HYG), have been chopping sideways for over a year.

The range in HYG has been quite narrow as well, with prices unable to break beyond a 10% move either up or down since late 2022.

This kind of trading pattern is just like water heating inside of a kettle. Eventually, the water’s going to boil, and all that steam will have to escape.

After a period of long consolidation, the market will eventually have to break out in one direction or the other. The longer the consolidation, the fiercer the breakout.

This sideways pattern in HYG is in sharp contrast to what we’ve seen in the stock market. The Nasdaq 100 index is up around 45% year-to-date, while HYG is only up 2.10% year-to-date.

This is an unusual divergence between two markets that are typically closely correlated.

Something will have to give sooner or later. Either junk bonds will have to catch up to stocks… or the stock market rally is going to fall apart.

Let’s look at a price chart of HYG to see if it offers any clues as to which way the markets will break…

HYG has been trading in a sideways triangle pattern since June 2022 (blue lines). Triangles are almost always trend continuation patterns.

They consist of two trendlines that funnel price action into a point called the apex. The apex of a triangle is where a breakout is most likely to occur.

As you can see, HYG is trading quite closely to that apex right now. Prior to trading within this triangle pattern, HYG was in a significant downtrend that started in September 2021.

This means it’s likely once the triangle pattern breaks out, it will lead HYG to lower prices. The key level keeping the triangle pattern together is the February 2 high of $77.20.

If HYG breaks above this level, then it would invalidate the entire pattern, and would mean having to go back to the drawing board.

On the other hand, breaking below the supporting trendline of the pattern would be great initial evidence that the triangle has completed and HYG is ready to start selling off.

Happy trading,

Imre Gams

Source: Jeff Clark Trader