Bonds Tremble, Stocks Yawn

New highs every day!  The vast majority of companies are beating earnings estimates!  All is great in the stock market, right?  It certainly seems that way.  Yet our colleagues in the bond market seem much more stressed these days.  It’s not yet noon and I’ve already been asked several times whether stocks can continue to blithely power ahead while bonds show signs of stress and volatility moves higher.  The answer is a resounding “yes, but…”

Short-term fixed income is supposed to be safe and boring.  Most of the time it is.  But that has hardly been the case for 2-year Treasury notes.  During October, the generic US 2-year yield has moved from 0.265% to 0.499%.  That’s about an 80% leap in a month, which is quite dramatic.^[i]  And the move in US notes is relatively modest compared to Canada, where rates doubled, and Australia, where they went up over 6X in that time period.  Furthermore, the US yield curve inverted for the first time in the 20-30 year region.  Since there is little logical reason for inflationary expectations to decline between 10 and 20 years from now and then resume in 20-30 years, it is much more likely that this was another sign of stress by a certain group of bond holders.

Sharp moves that defy explanation are often worrisome.  They usually mean that someone is in trouble – someone who is large and heavily leveraged.  There have been rumors and media reports to that effect, but as of now we don’t know whether it is truly the case.  But this should raise suspicions.  It is very rare for a major institution to have trouble in one asset class without it spilling over into another, particularly.  VIX appeared to be taking some notice, but only fleetingly.  We saw VIX spike to 18 on Friday as the US dollar rallied sharply against most of its peers – the type of currency that often has a negative impact on US stocks — but the VIX bounce faded as the S&P 500 Index (SPX) regained its footing.  VIX also traded above 17.5 this morning before fading back once again.  As of now, the bond market nervousness has not yet affected stocks. 

It appears that global bond markets are either beginning or in the midst of a taper tantrum.  The Australian and Canadian moves were in response to unexpectedly aggressive central bank tightening.  Unlike those other banks, the Federal Reserve is going out of its way to telegraph its intentions.  Yet it is clear that US fixed income traders are becoming increasingly nervous about the FOMC meeting on Wednesday, when the Fed is widely expected to announce that it will be tapering its $120 billion monthly bond purchases.   Stock traders seem quite sanguine about their expectations for tapering, acknowledging that it is highly likely, but not likely to be problematic nonetheless. 

At one level, it appears that stock traders are whistling past the graveyard.  But that isn’t the case if we look strictly at the relationship between stocks and short-term rates.  If we accept that a certain amount of stock buying is occurring because of “TINA”, there is no alternative, a few basis points here or there doesn’t change the narrative.  Besides, stocks have a history of delayed reactions to changes in monetary policy, often by 4-6 weeks or more.  Yet I’ve learned to trust the bond market when it comes to matters of economic policy.  Treasury bond prices are influenced almost exclusively by monetary conditions and inflationary expectations.  They aren’t distracted by the stories that stock traders love – earnings, technology, etc.  That is why if bond traders are nervous, stock traders should at least pay attention.

—

[i] To be fair, that overstates the move because the actual price of the note fell less than ½ point.  Short-term fixed income is indeed relatively safe and boring.