The bond market is trying to send a message to investors. Much depends on how they interpret it.
In recent weeks, the yield on 10-year Treasury notes Has risen to 4.15%, an increase of 0.28 percentage points over the two-year Treasury yield. It could mean one of two things: better economic growth in the future — or a big problem.
At first glance, the message in the bond makes sense. The two-year yield is more sensitive to changes in monetary policy, and the Fed is not expected to make any significant changes in its interest rate policy. This was confirmed after last week’s benign consumer inflation reading, which did nothing to change the disinflationary rhetoric. The chance of a rate hike in September is 11%. The 10-year yield rose, more responsive to growth expectations, as recession fears faded.
But there is a complicating factor: the move may not be driven by expectations of further growth. Earlier this month, the Treasury Department raised the estimated amount of debt it will have to issue during the second half of the year. Since then, investors have been more reluctant to bid on long-term notes and bonds at auction, driving prices lower and yields higher.
Don’t think the stock market hasn’t noticed. Last Thursday, and
S&P 500 index
It seemed poised to make significant gains after the July CPI report – until the end of the month 30-year bond auction. The auction results were disappointing enough to lift returns and cause stocks to give back gains, says Barry Knapp, director of research at Ironsides Macroeconomics. If this continues, it could mean more volatility in stocks and bonds.
Here’s the catch: Bond traders never look at the yields of individual maturities, but rather of multiple yields across different maturities—collectively known as the yield curve. They place their bets on whether the curve will “flatten,” meaning long-term returns will fall faster than short-term returns, or “slope,” when long-term rates rise faster than short-term rates. When the slope or flatness occurs as bond prices rise and yields fall, it is called a bull, and when it occurs in the opposite direction, it is called a bear.
With the 10-year yield rising and the two-year remaining roughly the same as it is now, the treasury market appears to be in a “Bear cleaner. It doesn’t happen often. The bond market spends about a third of the time in a bear flattening, a third of the time in a bull flatting, and a quarter of the time in a bull flatting, according to Ned Davis Research data. Bear regression occurs less than 10% of the time. “A bear slope is a relatively rare and unstable condition, especially late in a tightening cycle,” writes Joseph Kalish, chief global economic strategist at Ned Davis Research.
If the decline continues, that would be an odd message—one that counters the current narrative about muted growth, moderating inflation, and the Fed done raising interest rates. Instead, it seems to mean that growth is accelerating and that the data-driven Fed will continue to tighten.
“The overall message is that the economy is strengthening, and the Federal Reserve is expected to rise,” wrote Kalish colleague Ed Clissold, chief US strategist at Ned Davis Research. “In other words, the economy is getting the very clear message, but the Fed has not been over-tightening.”
History suggests this is a good thing for stocks. Clissold notes that the S&P 500 has gained 9.5% annually during the bears’ downturn, which is only slightly worse than it did during the bear-and-bull downswing. Stocks averaged 1.9% up during the upward slope, when the Fed was cutting interest rates, likely due to the recession.
Denis Debuschery, founder of 22V Research, credits this year’s rapid inflation for the bear trend, which points to better growth prospects ahead. He writes: “The (burden) has shifted and evidence that … growth is not the driver of the curve is needed before we get more defensive.”
Include stocks that benefit from a steep yield curve
(Stock ticker: GNRC),
But what if the bear’s decline wasn’t driven by growth? Ironsides’ Knapp sees signs that movement in long-term yields is being paid off The massive supply of bonds coming from the US government. Bear cleanups that rely on oversupply are very rare, and they wouldn’t be doing well if that were the case now, he says. It is estimated that continued decline could cause the stock market to fall 5% to 7%. “(The) bears were a warning shot,” he explains.
The good news: The Fed may finally force an end to this rate hike cycle once and for all and provide a buying opportunity.
write to Ben Levisohn at Ben.Levisohn@barrons.com