Short sellers are targeting high yield corporate bonds as HYG continues its plunge.

HYG chart

Institutional investors and hedge funds are betting against U.S. corporate credit as insurance against a recession that might be coming.

Vice President Pence basically said over the weekend that the US will more than double its tariffs from 10% to 25% against China if China does not give the U.S. the deal it wants by January 1 2019.

No deal looks like its coming before January 2019 and this will have a big negative impact on the stock market.

Consider Ford, the second largest U.S. automaker by sales, said that Trump’s tariffs have cost the company $1 billion in the form of lost auto sales because of tariffs on metals and other goods. Morgan Stanley estimates that Ford will lay off 24,000 workers globally. Imagine how many other Ford like headlines will hit markets in Q1 2019 when tariffs go up to 25%. Forget about whether you agree with the trade war or not. The point is, tariffs are going to more than double in January 2019 and that’s going to have a big negative impact on EPS and revenue growth next year unless a deal is reached.

The best way to play the economic slowdown in the US is by shorting corporate bonds and high yield bonds, or using credit default swaps.

Investors are selling corporate bonds and instead buying Treasury bonds as evidenced by the spread between Treasury bonds and corporate bonds on the chart below.

Investment grade yield spread chart

As the Fed hikes rates, the risk of holding corporate bonds rises because of the slowing economy. Furthermore, rising rates make Treasuries more attractive as they have far less risk. Higher Treasury yields makes Treasury bonds more competitive with corporate bonds in terms of yield too.

Shares of U.S. homebuilders and automakers have already entered bear market territory because of rate hikes, with both down more than 30% since hitting an all-time high in January 2018.


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