Stocks vs. Bonds: "Something's got to Give"

05/02/2017 2:45 am EST

Focus: ETFs

Jim Woods

Editor, Successful Investing and Intelligence Report

The market so far in 2017 has been surprising, and not just because of the spike to record highs we saw over the first two months of the year, explains Jim Woods, editor of Successful ETF Investing.

 Lately, the biggest surprise in markets has been the decline in long-term Treasury yields, and the subsequent warning sign that could be for equities.

When I first started in this business some 25 years ago, I was taught not just to watch what was happening in stocks, but also what was taking place in other asset classes.

The reason why is because knowing what’s happening in other assets (bonds, gold, commodities) often allows you to confirm (or not confirm) a move in the stock market.

Right now, we are getting notable non-confirmation of the equity move from the bond market. The reason why is because in a healthy economy, bond yields tend to rise as they reflect investor expectations for future economic growth and inflation (i.e. another example of “hope” at work).

There also tends to be a steepening of the yield curve, which reflects rising inflation expectations and increased demand for money via loans.

Then there’s the “riskier” parts of the bond market such as “junk bonds,” which tend to rise and/or remain stable as investors show confidence via lending money to riskier companies.

Late last year, the bond market confirmed the uptrend in stocks. The yield on the 10-year Treasury rose from a low of 1.54% in September to 2.40% at year end. The yield curve also steepened while junk bonds were basically flat during that period (although there was some notable volatility).

This year, we’ve seen nearly the opposite take place. The 10-year yield started the year at 2.44%, but it has fallen to 2.20% as of April 19. See the CBOE 10-Year US Treasury Yield Index ($TNX) chart below.

chart 1

Meanwhile, the yield curve has flattened and junk bonds began to tumble in early March — see the SPDR Barclays High Yield Bond ETF (JNK) chart featured below.

chart 2

And while the junk bond market has stabilized in April above the 50-day moving average, any pronounced move to the downside will be cause for concern regarding the future of the equity hope rally.

The bottom line is the bond market is reflecting an outlook calling for slower economic growth, less inflation and modest equity moves... which is not the reality being reflected in the equity market since the election.

Something’s got to give, as the saying goes, so keep your eyes on the bond market. It might be the clearest signal yet on what’s coming for stocks.

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