Global stocks posted their first weekly rally since early June for the week ending July 18th. Last week, the Dow gained 3.6%. Normally, a strong equity market rally would be confirmed by gains for credit indices, as investors raise their risk parameters and buy high-yield bonds and other risky fixed-income securities.

But this rally, a dead-cat bounce in my book, has not been confirmed by tightening credit spreads across most investment-grade credit markets. Also, high yield or junk bond yields continued to widen, not narrow, last week. And finally, LIBOR or the London Inter-bank Borrowing Rate, was unchanged last week suggesting inter-bank lending remains nervous. Worse, long-term mortgage rates widened to 6.44% last week from 6.25% a week earlier – another dose of bad news for the housing industry.

Like I’ve said all along in these pages, if you want solid proof of credit market normalization, then look at credit spreads, not the stock market.

Investment-grade bond indices are particularly fragile. Though we’d expect high-yield or junk bond yields to continue rising in a growing environment of defaults, this shouldn’t be the case for high quality corporate debt. Most non-financial companies have already refinanced prior to the emergence of the credit squeeze last summer and have reduced net debt levels since 2002. Credit spreads for these companies should be lower, not higher.

Last week’s equity market rally should have carried investment-grade corporate bond yields lower; instead, the Dow Jones Corporate Bond Index saw yields widen to 6.24% from 6.04% a week earlier – a bearish sign. That’s the highest spread compared to Treasury bonds in 12 months and indicative of a worsening, not improving, credit environment.

Another set of credit indices also supports this bearish development.

The Markit CDX Index, which tracks a broad set of global credit markets, reveals that most sub-components of this index are still hemorrhaging.

Even though stocks posted big gains last week, most of the constituents in this series hit new lows – including North American Investment Grade indices, North American High Yield indices and the Emerging Markets credit indices. In Europe, however, investment-grade and high-yield credit markets actually rallied off their lows. But this trend seems to be an aberration in a bigger downtrend for all credit indices.

Then we’ve got mortgage giants, Fannie Mae (NYSE-FNM) and Freddie Mac (NYSE-FRE). Many North American credit indices are suffering this month mainly because of big declines in Fannie and Freddie debt.

Both agency’s have seen their respective mortgage-backed bonds hit hard over the last two weeks as fears of collapse surface. I highly doubt Fannie and Freddie will go bankrupt because combined they finance more than 50% of all U.S. mortgages; a collapse would literally destroy what’s left of an already battered mortgage industry. Agency bonds therefore look attractive at these levels but I wouldn’t touch Fannie or Freddie common stock. PIMCO, probably the world’s best bond fund managers, remain very bullish on Fannie and Freddie debt.

This stock market rally is a dead-cat bounce led higher by bombed-out financials. If stocks continue to power ahead this week, be sure to follow credit spreads. A further widening of credit spreads is a bearish omen for the market and the economy. Until spreads begin to narrow again, investors should remain extremely cautious.