The availability of credit, to borrow, spend or invest, is the lifeblood of the financial market. That’s why credit conditions are a good indicator of risk appetite. The easiest way to gauge real time credit conditions is by observing the yield differential between 10-year, BBB bonds and 10-year Treasury notes. Since the bond market is roughly seven times the size of the stock market, the yield premium lenders require to extend credit to lower-quality borrowers is a useful barometer.
Rising credit spreads can also be early warning indicators of trouble. Our credit spread model broke out in Q4/2007, four quarters – an entire year – before trouble swept through the broader markets. While credit conditions are favorable today, spreads have widened in recent weeks and are currently situated just below their 200-day moving average. Continued widening would be a risk-off signal.
Favorable credit conditions along with a favorable economic backdrop, reasonable equity market valuations and positive momentum are keeping us engaged in equity risk-taking. That could change should credit conditions deteriorate.