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What Higher Interest Rates Mean for Junk Bonds

Hot interest rate; Shutterstock ID 360707312; Project: LBE

Larry’s note: Welcome to Trading with Larry Benedict, the brand new free daily eletter, designed and written to help you make sense of today’s markets. I’m glad you can join us.

My name is Larry Benedict. I’ve been trading the markets for over 30 years. I got my start in 1984, working in the Chicago Board Options Exchange. From there, I moved on to manage my own $800 million hedge fund, where I had 20 profitable years in a row. And, I’ve been featured in the book Market Wizards, alongside investors like Paul Tudor Jones.

But these days, rather than just trading for billionaires, I spend a large part of my time helping regular investors make money from the markets. My goal with these essays is to give you insight on the most interesting areas of the market for traders right now. Let’s get right into it…

There are no guarantees when it comes to the markets.

However, an interest rate rise in March looks almost certain.

The question is how big that rise will be…

This past week, several prominent hedge fund managers have been calling for a rise of 0.5%. Others are also joining in the prediction that the Fed will have to raise rates more than four times as it tries to get back in front of the inflation curve.

With so much speculation, an increase in volatility is never far away…

Yields on treasuries were rising in anticipation of future rate hikes. In just the past year, yields on 10-year bonds rose from around 1% to nearly 1.9%… 0.4% of that rise has happened since the start of the year.

In the bond market, that’s a massive move.

That plays out not only into the stock market, but also into the wider bond markets… including the junk bond market – represented by the iShares iBoxx $ High-Yield Corporate Bond ETF (HYG) below.

When interest rates are low, money finds its way into riskier investments (like junk bonds) as investors chase yield. However, when interest rates start rising, that money starts to flow the other way into less risky government bonds.

As you can see below, after tracking sideways for much of last year, HYG began to trend lower in September. That’s shown by the 50-day moving average (MA – blue line) moving lower…

iShares iBoxx $ High-Yield Corporate Bond ETF (HYG)

Source: eSignal

After that high in September (1 on the chart), HYG has gone on to make two lower highs. First on November 8 (2), and then right before the end of the year on December 27 (3). While it’s still early in the current move, a series of lower highs typically signifies a downtrend.

The fall will soon see HYG test support (green line). A break below this support will further confirm a downtrend.

Right now, I’m also watching the two moving averages…

Throughout the past 12 months, the short-term 10-day MA (red line) and the long-term 50-day MA have criss-crossed multiple times as they tracked each other closely. Most recently, the 10-day MA crossed down below the 50-day MA back on January 10.

For the current down move to gain traction, we’ll need to see the 10-day MA break further below the 50-day MA. A widening gap between two moving averages shows that a trend (in either direction) is gaining momentum.

In the meantime, HYG is going to run into another test on the Relative Strength Index (RSI). As you can see, the RSI is closing in on oversold territory (lower grey horizontal line)…

iShares iBoxx $ High-Yield Corporate Bond ETF (HYG)

Source: eSignal

When the RSI went into oversold territory in October (A) and formed a ‘V’, HYG bounced but quickly ran out of momentum. While the bounce off ‘B’ showed greater strength, HYG topped out at the lower high at ‘3’.

Meaning that even if we get some support at ‘C’, any bounce also might be short-lived. If HYG were to bounce off an oversold signal at ‘C’ and then make another lower high, that could set us up for a short trade.

Right now, the chart is showing us that in the short term, momentum is going against HYG. For HYG to consolidate and move back higher, first it must hold support.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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