The "danger signal" of the US stock market rally: widening credit spreads

In the past few weeks, the US stock market has stagnated after a decent rebound following the easing of panic sentiment from the tariff turmoil. However, the positioning in the credit and foreign exchange markets suggests that the recent stock market rebound may end under any circumstances.

Before the recent turmoil in the Middle East, global credit spreads have been widening over the past few days. Additionally, last Wednesday, the actual volatility dropped to very low levels, making it more challenging for the S&P 500 index to rise further to higher levels.

High Credit Spreads and S&P 500 Earnings Yield

For many years, the CDX high-yield credit spread index has been closely correlated with the earnings yield of the S&P 500 index, indicating that when credit spreads widen, stock market price-to-earnings ratios decline, and when credit spreads narrow, price-to-earnings ratios rise. Recently, it is noteworthy that the decline in the earnings yield of the S&P 500 index has been much greater than the equivalent decline in the credit spread index.

Global Spreads are Widening

A similar spread trend exists in Japan, although European spreads have narrowed to pre-"panic" levels. This indicates that the credit market, like the US stock market, lacks confidence.

However, there is a significant change in Europe: the 10-year euro swap rate has risen after first dipping into negative territory at the end of 2024. The euro swap spread measures the difference between the 10-year euro interest rate swap rate and the 10-year German government bond yield. Although it is not entirely correlated with the trend of the US high-yield spread index, the trends are similar. More notably, the recent 10-year euro swap spread has been rising and diverging from high-yield spreads.

Cross-Currency Basis Swap Spreads

When analyzing the cross-currency basis swap spreads of the euro and yen relative to the dollar, the situation is roughly the same. These spreads have been rising and are approaching zero. This indicates that the cost of dollar financing has decreased, and more importantly, this aligns with the trend of narrowing credit spreads observed during the transition from 2024 to 2025. Like those credit spreads, these cross-currency basis swap spreads have also stopped their upward trend and have begun to decline.

When these basis swap spreads reverse and are compared with the current U.S. high-yield bond spreads, it becomes easy to see their co-movement. However, recently, the spreads of the yen and euro have diverged from the U.S. high-yield bond spreads, indicating that the U.S. high-yield bond spreads are likely to rise further.

Ultimately, spreads are widening globally, suggesting a shift in the attitudes of some market participants. Given this relationship, the widening of credit spreads and the rising cost of dollar financing imply that the price-to-earnings ratio of the S&P 500 index should contract and show a downward trend.

Currently, credit spreads seem to be moving in a different direction from the stock market, which does not mean that the direction of the spreads will not change. However, observing their trajectory may still provide valuable warning signals for the direction of the stock market, which is worth close attention