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Do Warning Signs In The Bond Market Point To A Big Correction In The FTSE 100?

The FTSE 100 is down 1.4% on Thursday at the time of writing, and once again the index trades below 7,000 points. 

“Crude prices rose as much as 6 percent on Thursday after Saudi Arabia and its allies launched air strikes on Yemen, pushing shares lower in Europe, the Middle East and Asia and lifting oil producers’ currencies,” Reuters reported today as most equity markets around the globe were in negative territory. 

While you can’t predict these events, there are other elements that will help you determine whether the FTSE 100 will rise or fall in future. 

Let’s take a look at the bond market. 

Bonds

Historically, the bond market tends to anticipate big moves in the equity market. So, any signal coming from it, or any comments from market operators, should be closely monitored.

“Traders warn of a global credit ‘meltdown’ if corporate bond markets don’t improve,” The Telegraph recently reported.

It’s not that simple.

And it’s a problem for the traders, rather than a massive headache for the equity market!

In fact, the FTSE 100 could benefit from volatility in the bond market these days.  

Traders!

So now bond traders are worried that liquidity may disappear overnight. With declining interest rates, and flattening yield curves, they have made a bundle in the last few years — yet they can’t get enough.

They need to heighten the perception of risk among the public, but that’s how they can profit from volatility. 

I am a big fan of bonds, and I have recorded an outstanding performance in the last couple of years betting on the long-end of yield curves around Europe — bonds with maturities longer than 15 or 20 years.

It’s getting tougher now, of course. 

You may not know, but prices and yields at the long-end of most yield curves have become highly volatile in the last few trading sessions, which signals nervousness in the market.

Some traders are taking profit more swiftly than in the past, and are concerned about lowly real yields.

Furthermore, it looks like even bonds with maturities shorter than five and seven years are seriously overpriced. So, should bond traders worry about a paucity of value candidates in the market right now?

Of course they should, but there’s nothing they can do because, barring Europe, interest rates will have to go up sooner rather later. As interest rates rise, prices fall — there’s no way around it. 

But this environment forces me and other bond folk to look for valuable candidates outside the debt markets, and pour cash into the equity markets — which, in turn, will benefit shares. 

Liquidity Crunch & Loan Market

Several bond market sources have told The Telegraph that it’s really bad out there.

“Some investors are beginning to fear that the lack of liquidity will be the spark that ignites the next crisis in financial markets,” The Telegraph insisted. 

But most companies around the world have recapitalised their balance sheets in recent years, so leverage is less of a problem than in the 2005-2009 period.

If the bond market shuts down, it will certainly have a big impact on global markets worldwide — but how long will it last? It’s hard to say, but if the other engine of credit, the loan market, continues to work smoothly then any damage could be limited, and may yield just a lower degree of diversification in any borrower’s funding sources. 

Commercial banks are keen to lend to corporate clients in a market where the number of lenders and fees has plunged since the credit crisis. But what if another credit crunch is around the corner? 

Well, then the lenders will figure out a solution, as they did in late 2008 when nobody trusted the Libor rate any more. In those days, in order to find a way to price certain debt facilities, the banks came up with the smart idea of pricing loans against a borrower’s credit default swaps…

So, take it easy, do your homework and keep hunting for value in the equity market: you just need to find a solid investment at the right price, and I suggest you consider a company worth £1.2bn, whose name in included in our free investment report

This company's shares have almost doubled in value in 12 months, but still look attractively priced, to be honest. 

This is a debt-free company with a forward yield of 3% that is growing earnings at 20% a year, and is just as attractive as other businesses whose valuations have surged in recent months, but still trade in bargain territory.

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.