Are swap spreads forecasting a huge corporate bond rally?

Swap spreads tend to be leading indicators of the price of risky assets, especially in today's market. That's because the financial crisis we're struggling through is dominated by credit risk and more specifically counterparty risk. Big money is afraid to trade because of the risk that their trading partner might be the next institution to succumb to a government takeover or fall victim to plunging prices on subprime-related assets. High swap spreads represent the level of fear that is gripping the market. Markets have been frozen as a result, with liquidity all but nonexistent. With some institutions still being forced to sell assets into an illiquid market, prices have been severely depressed, and yields have soared.

Things are improving on the margin, however. Swap spreads have come down meaningfully, but are still abnormally high. As this chart shows, short-maturity swap spreads have been a good leading indicator of the distress in the junk bond market. In the past few days, yields on junk bonds have finally started to come down from the stratosphere, following the lead of declining swap spreads. If both these trends continue, high-yield bond prices are set to soar.