Stock Market vs. Bond Market: Is One Right and the Other Wrong?

Does the bond market know something stocks don't?

The S&P 500 chart looks as though the fourth quarter was just a bad dream. The index is less than 5% away from a new all-time high, up almost 19% from the lows. But no one told the Treasury bond market, where the 10-year yield is only 8 basis points off its lows.

Is one market right and the other wrong?

With talking heads breaking out the old trope that the bond market is smarter than stocks, let's take a look at what each market is telling us.

The Fed Is Driving Everything

During the 2018 selloff, there were various reasons given, including the trade war, slowing China growth, plunging business investment, etc. However, it now seems there was one dominant factor: monetary policy. The market was assuming that the Federal Reserve was going to keep hiking until the U.S. economy faltered. Now that the Fed has made an about-face and seems on hold for the foreseeable future, stocks have recovered.

This also explains why Treasury yields haven't moved higher. Why should they? If the fed funds is going to peak at around 2.375% (the mid-point of current policy range) why should the 10-year Treasury be much higher than that?

I often hear people talking about Treasury yields as though they are a fear gauge. They can be a fear gauge, but most of the time they mainly reflect the market's expectations for future Fed policy. Yields tend to fall when the economy is weak in large part because the market expects the Fed to cut in the future.

No Confirming Evidence of a 'Fear' Trade

If the bond market "knew" something stocks didn't, we'd have confirming evidence from the credit markets.

In 2007, when stocks kept rising until late in the year, the credit markets had been showing weakness for months. Today credit spreads have retraced most of the fourth-quarter widening, similar to the movement in stocks. This wouldn't be happening if this was a fear trade.

That's Good News and Bad News

So, this explains why yields aren't rising and why there's no particular reason to fear that. However, it puts risk markets in a tough spot.

If the macro economy regains momentum, the Fed will be back to hiking. There's no more juice left to squeeze from a Fed that's merely on hold.

Now we need earnings to recover without triggering more hikes for risk assets to keep rising. That's a very narrow scenario. Could happen, but its narrow.

History Confirms Fed-Based Rallies Are Tough to Trade

This is why I've said that Fed-driven rallies are tough to buy.

I looked back at every 15%+ S&P 500 selloff over a two-month period since 1990 (there have been nine discreet incidents of these excluding the one that just happened). Six of the nine occurred during or near the outset of an extended bear market. Of the remaining three, two were rescued by Fed action: one in 2010 ahead of QE2 and one in 1998 during the Asian crisis. The remaining episode was in 2011 near the Greek default.

What this brief history lesson shows is that easier monetary policy can rescue us from a bear market, but only if the economic fundamentals also rebound. Fed policy by itself isn't enough.

Some Vulnerability in the 2-Year, None in the 10-Year

Right now, we are seeing mixed data. Employment seems steady, recent factory and housing reports have been weak. I don't know for sure which direction the economy is going to break. However, the bar for the Fed to hike rates is now extremely high:

1. They don't want to go back on their word, having talked up "patience" so strongly
2. They don't want to repeat December's selloff
3. Inflation has slowed a bit
4. European and emerging markets growth seems to be slowing, which creates new risks for the U.S.

This will put a ceiling on how high interest rates between 5-10 years can rise. For this part of the curve to be meaningfully higher, the Fed has to resume hiking, and probably multiple hikes. I don't think this part of the curve would move at all if the Fed did one hike, but additional ones were not anticipated. The 2-3 year part of the curve would probably rise and invert that longer part of the curve.

Meanwhile, if economic fundamentals don't rebound, the Fed will start cutting rapidly. I think this creates a trade with good upside and only minor downside.

On Credit, Stay Short

A couple weeks ago I mentioned we are buying shorter-term high-yield bonds. I'm doing it directly in bonds, but I mentioned two ETFs that are both up a bit: PIMCO 0-5 Year High Yield Corporate Bond (HYS) (+0.9%) and SPDR Bloomberg Barclays Short Term High Yield Bond (SJNK) (+0.6%). I still like this trade.

In credit right now you want to focus on carry without a lot of principal risk. These kinds of bonds fit this bill well.

At the time of publication, Graff was long 5-year, 10-year, and Ultra 10-year futures.