This week, rather than taking a shorter-term trading view of the markets, I’m taking a more long-term, “30,000 foot” view of the bond market vs stock market. I don’t allocate capital or take trading positions based on this broader view. However I do find it helpful to look at the big picture from time-to-time, so I can be aware of any major shifts taking place and hopefully avoid any major surprises.
Interest rates are the most important market to watch right now
I described the US 10 year Treasury yield as the most important number in finance in my post of 4th February. This is because it is likely that a multi-decade long reversal is currently taking place in bond markets.
This is something that hasn’t happened since 1981 when US 30 year bond yields hit 15.8%. Since then bond yields have been steadily trending lower.
What this means is that a significant bear market in bonds could be just getting started. It’s important to remember that bond yields rise when bond prices fall. A bear market in bonds (falling bond prices) thus creates an environment where bond yields and hence interest rates steadily rise over time.
Below is a chart of the 30 year US Treasury Bond. This looks to have broken the uptrend line dating back to 2005 together with what looks like a head-and-shoulders top formation.
Remember, falling bond prices (as indicated by the chart above) lead to rising interest rates.
Bonds and inflation
This nascent trend towards falling bond prices/rising interest rates will be exacerbated by any signs of inflation. Bond markets hate inflation! Because bonds pay a fixed interest rate over the course of their life, bonds lose value during periods of inflation.
Bond yields are a function of the market’s long-term expectations for economic growth and inflation. If both are expected to rise over time, bond markets will price this in by marking bond yields higher. Higher bond yields not only increase the cost of borrowing for the US government. They also result in higher interest rates on all types of loans and mortgages.
That’s right, higher bond yields mean higher mortgage rates…which means less money in consumers’ pockets. Thus the implications of rising boned yields are far reaching across the economy.
Bonds have been sold down recently on the back of:
- The stronger US economy. Remember, as economic growth expectations rise, bond yields will tend to rise to match these expectations
- The Fed’s recent policy of quantitative tightening
- Concerns that China may curtail their purchases of US bonds on the back of a US/China trade war
- Technical signals, such as the trendline break and head-and-shoulders top highlighted in the chart above
The impact of rising interest rates
The diagram below is a simplified explanation of the impact rising interest rates have across the economy:
Rising interest rates are a headwind to economic growth because they tend to curtail investment and consumption in an economy. Further, when bonds and bank deposits offer higher interest rates, stocks become relatively less attractive as investments. For all of these reasons, rising interest rates are seen as a headwind for the stock market.
This is why stock investors need to pay attention to what is going on in bond markets. Particularly if bond markets are undergoing a change in a multi-decade trend.
Bond yields and earnings
The diagram below shows the four possible environments of rising vs falling interest rates and earnings and how they impact the stock market:
An environment of falling interest rates and rising earnings is the most bullish environment for stocks. This is what we saw throughout the 2009-2014 period. An environment of rising interest rates combined with rising earnings can be positive for stocks provided the rise in rates is measured. This is the environment we saw throughout 2017 which was a very bullish phase for this market.
Falling rates and falling earnings is a mixed bag for stocks. Falling earnings is obviously bad but this can be partially or completely offset by falling interest rates. This environment can see stocks rise or fall depending on other factors such as sentiment and valuation.
The most bearish environment for stocks is rising interest rates and falling earnings. This is what equity investors need to be on the lookout for. It is very tough for stocks to rally in this environment. In fact, this environment usually corresponds with a bear market.
What about the Federal Reserve?
So far this discussion has only covered bond yields. The Federal Reserve explicitly sets short-term interest rates in the US economy via the Federal Open Markets Committee (FOMC).
The market determines bond yields via supply and demand for bonds. The Federal Reserve has no direct control over bond yields, although it can exert influence over them via QE (and now, QT).
The Fed is on course to reverse the easy money policy that defined the GFC-era by increasing short-term interest rates and reducing the size of its balance sheet. The Fed wants to increase interest rates in order to:
- Head-off nascent signs of inflation
- Cool an economy that is effectively at full emplyment
- Build some “bunker protection” for when the next recession hits (i.e. so they can cut rates from somewhere)
But the Fed is in a tricky spot, akin to walking a tightrope. Consider the following:
- US national debt now exceeds $21 trillion. This debt is not going down any time soon. In fact, it’s only going to get bigger for the foreseeable future
- US Consumer debt now exceeds $13 trillion, higher than it’s previous peak in 2008
- The US wants a weaker dollar, to maintain export competitiveness. The US trade deficit is ~4% of GDP.
These are three important reasons why the Fed cannot tighten interest rates too much.
Impact of tighter Fed policy
Interest rate hikes by the Fed have the following negative implications:
- Rising rates will increase the debt burden on the US government / US taxpayer
- They will tend to strengthen the US dollar, reducing the competitiveness of US exports
- Low unemployment + rising rates in the economy will tend to trigger inflation expectations, which will only see bond yields rise further and faster
So while the Fed needs to raise rates, they can not raise them too much or too quickly lest they so the seeds of what they are trying to avoid by raising rates in the first place (i.e. inflation).
A red flag I wish to point out is the breakdown in the utilities sector (see chart below):
Utilities look to have rolled over and this is concerning because the utilities sector is a leading indicator for inflation. Utilities stocks tend to perform badly during a rising interest rate cycle and this rollover in the sector is an indication that the market expects interest rate hikes are here to continue.
Recent yen strength and Aussie dollar weakness in the forex markets also have my attention…
These are longer term issues
I must mention that these factors – a change in trend of 30 year bond yields and the potential for higher interest rates and inflation – are only going to impact markets over the longer term (measured in months and years, not days and weeks). We are not going to wake up next week to roaring inflation and double-digit bond yields and a stock market that is 40% lower as a result.
But is important that we take note that factors in the markets that have been tailwinds for so long (falling rates, rising earnings) will not be tail winds for ever and in the case of interest rates, a headwind could be building as we speak.
Current state of the stock market
The NASDAQ, tech stocks and semiconductor stocks remain on fire. Consumer staples and utilities are in trouble while the S&P 500 remains stuck between key mid-range levels:
Until SPY can break the 78.6% retracement level shown on the chart above it will remain range bound. I noted last week that the NASDAQ was making new highs and that it looked likely it would lift the rest of the market with it. This hasn’t happened yet.
This week could be an important one for the SPY. If it closes above the 78.6% level the markets should be off to the races again. However if it closes below the 61.8% level we will likely see a retest of the 50% and even the 38.2% levels (as per the chart above).
The US economy remains strong, consumer confidence is strong, earnings are strong and manufacturing is strong. Trade wars, inflation and interest rates are headwinds and this is the tug-of-war the markets are currently facing.
The US Leading Economic Index is still printing record highs. This usually flattens out and declines several months before a recession. Current readings indicate there is no recession in the foreseeable future.
The market will remain in a tug-of-war until we get a clear break one way or the other. I am expecting a break to the upside but my positions remain light and I’m maintaining some short exposure just in case things turn down instead of up. Good trading!