One of the most alarming signals in decades has been recorded in the credit market. For the first time since 1998, primary dealers have taken a net short position on corporate bonds, which they typically hold in inventory. This amounts to approximately $4 billion for this year. This means dealers have sold more credit risk than they actually hold on their balance sheets.
For comparison: in 2017, the same banks held an average of $16 billion in such securities at their peak. The shift from a large long position to a short one is an extremely telling moment. Bull Theory sees several possible reasons for this scenario. Either banks are quietly fearing a weakening of the credit market, or demand is too high to hold bonds in inventory. There is another option — electronic trading has completely eliminated their need for such inventories.
Long-Term Debt in the Crosshairs
The bulk of the short positions are in long-term debt — $13.7 billion in securities with maturities of five years or more. This portion is partially offset by a long position of $9.66 billion in shorter-term issues. It is long-term securities that are most sensitive to rising yields, so dealers are exercising maximum caution with them. Meanwhile, credit spreads are hovering near multi-year lows, meaning dealers receive extremely little compensation for this risk.
Researchers see a particular danger in a potential rebound. If bonds start to rise, dealers may be forced to cover short positions in a market with almost no supply, turning a comfortable position into a rapid and sharp reversal. Historically, as Bull Theory reminds us, the credit market usually cracks before the stock market does.
Contrast with the Stock Market
This alarming signal unfolds against an unusual picture in the stock market. According to analyst Charlie Bilello, earnings of S&P 500 companies could grow by 24% this year. The expert emphasized that the market has not seen such high rates outside of recovery periods after recessions. He called it an "unprecedented boom," fueled by a sharp rise in earnings per share among major technology companies.
Both pictures complement each other. Record optimism in stocks and near-zero compensation for credit risk point to one thing: the market places an extremely low probability on problems. This is what makes it vulnerable to a sharp reversal.
Expert opinion: Such a divergence between the stock and credit markets is a classic precursor to a correction. When dealers, who understand risks best, are massively exiting debt, while stock investors continue buying at highs, it signals overheating. The cryptocurrency market, as the riskiest asset, could react to such a reversal first and most painfully.