Signs of irrational exuberance appear to be emerging in the junk bond market, and they could end up being a bad omen for stocks.
Fundstrat Global Advisors' Tom Lee finds the rally in the European high-yield market troubling.
"That market has rallied relentlessly this year," the firm's head of research and managing partner said Monday on CNBC's "Trading Nation." "Unlike U.S. high yield which if you pull up [iShares iBoxx $ High Yield Corporate Bond ETF] HYG's chart it's acted flat, European high yield has had a great rally this year. But, it's pushed the level of yield in Europe to 2.17 percent."
The high-yield or junk bond market boasts the lowest quality of credit and has the highest risks of default in the fixed income space. The area often exhibits equity-like behavior, and it's often seen as a key stock market indicator.
"High yield historically rallies before stock markets finally bottom," Lee added.
He did some math that suggests the problem may be bigger than many investors realize.
"A European junk bond issuer can borrow money cheaper today than the U.S. government. And, if you're double-B rated in Europe which is the higher end of junk in Europe, you're borrowing at 1.6 percent," he said. "So, you're borrowing 50 basis points cheaper than the U.S. government if you're a junk bond issuer in Europe."
Plus, Lee points out in a recent research note another — perhaps more disturbing — issue that's creating a "moral hazard."
"The second problem is that European high-yield bonds are now implying a negative default rate. They are implying that nobody who's a junk bond issuer in Europe will ever actually default on a bond," he said.
Lee is blaming European monetary policy for the pricing distortion among European junk bonds. He's worried the risk will spill into the U.S. high-yield market — noting that this area rallied here just before the financial crisis erupted in 2008.
"That would be, I think, the thing that's getting me very nervous," Lee said.
