Bond Market Scares Stocks into Drop

05/15/2014 12:00 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

As the markets drop today, MoneyShow's Jim Jubak explains some of the reasons behind the scare.

Markets can scare themselves—and that seems to be what's happening in US markets today. As of 2 pm New York time, the Standard & Poor's 500 was down 1.06%; the Dow Industrial Average is off 1.2%; and the small cap Russell 2000 is down another 1.39%.

However, bond prices, which rise when yields fall, have climbed today with the yield on the 30-year Treasury hitting its lowest level since June 2013 at 3.34%.

The logic of the move in stocks—lower—and in Treasuries—higher—isn't immediately obvious since US economic data were, in general, strong this morning. That should have sent bond prices lower (and yields higher) on fears that stronger economic growth would lead to higher inflation and higher interest rates. That data should also have sent stocks higher on hopes that stronger economic growth would backstop stock prices.

So what's driving prices in this unexpected pattern?

Let's start with context. By the time US financial markets opened this morning, the news backdrop from China and Europe was solidly negative.

First, electricity consumption in China, a widely followed indicator by economists and analysts who don't trust the official GDP figures, slowed to 4.6% year-over-year growth. That was a drop from the previous 7.2% growth rate. If you're worried that China's economy is going to slow more than expected, here was confirmation that you're right to worry. The Shanghai Composite lost 1.1%, falling for the third straight session. Commodity stocks took even worse punishment—Yanzhou Coal (YZC), for example, fell 4.9% on fears that if China's economy slows demand, commodities will plunge.

Second, data from Europe showed EuroZone GDP growing at an even more anemic rate than expected with GDP climbing just 0.2% quarter over quarter. The consensus among economists had been looking for 0.4% quarter over quarter growth.

The German economy was one of the few EuroZone economies to turn in better than expected growth with a 0.8% quarter over quarter increase against the forecast of 0.7%. The year over year GDP growth rate moved up to 2.5% vs. consensus projections for 2.2%.

After that, though, the picture was pretty grim. French GDP was unchanged from the previous quarter against previous growth and expectations of 0.2%. Italian GDP actually fell 0.1% from the previous quarter against the consensus forecast of 0.2% growth.

So, that was the context for this morning's economic numbers in the United States. The data was mostly positive although industrial production disappointed with a 0.6% drop vs. expectations for no change. Initial claims for unemployment provided the big positive news as it fell to 297,000 for the week versus 319,000 in the previous week. That was the lowest initial claims number since 2007. Economists surveyed by Briefing.com were projecting 325,000.

What seems to have spooked the stock market is the bond market's response to the good news on initial claims. With the economy showing more strength than expected—fewer people applying for unemployment is usually a sign of a pick up in growth—bonds should have sold off and yields should have ticked higher. But exactly the opposite happened.

And that left equity traders scratching their heads. Was there something in the numbers that they weren't seeing? Did the bond market not believe the strengthening story? And even if the bond market's logic was completely wrong, a continued rally in bonds made that asset an attractive short-term competitor to stocks.

That isn't much of a reason for stocks to move lower, but it has been enough today as the market tests the 1900-level on the S&P 500 and as the big cap indexes trade at all-time highs. The continued drop in small cap stocks—represented by the Russell 2000—has started to raise some worry. As long as the drop in the Russell can be dismissed as rotation into big caps then there's nothing for the market as a whole to worry about. But on a day when all the indexes are moving lower, the performance of the Russell is enough to raise concern that the market as a whole is vulnerable to a drop.

Which is how the market has scared itself today.

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