Should the Stock Market Worry About Rising Bond Yields?
The rising yields in treasuries that we are starting to see lately has some people worried that this might put downward pressure on stocks. Should we worry about this?
The fact that treasury yields have been rising for a while now, since last August in fact, really should not come as any surprise to anyone who knows even a little about these things. People buy more treasuries in times of economic decline, and back when the stock market crashed last February, we chose to recommend not shorting stocks during this time but to instead use leveraged treasury funds to cash in on this, because this was the most reliable play you could make at the time.
This is what they call a flight to safety, and this turned out to be the perfect call as long as you only hung around for the flight. The party lasted less than a month, but this was as sure of a bet as you will ever see, knowing that bond prices will go up due to this extra demand that the stock market scare produced.
Bond prices shattered all-time records, meaning that yields hit all-time lows, by a big margin in fact, seeing the 10 year yield drop down to 0.31%. A couple of weeks later, the 10 year was over 1% again, which shows you how critical timing is when trading bonds, even during times of turmoil.
When you blow away the records, as the distance between current yields and average yields get expanded like a drum, this simply cannot continue indefinitely. The trend being decidedly bearish for bonds, meaning yields rising, was something we could be very confident with, and this is what you call a real bubble, with the difference between where yields are normally given the current economic circumstances and where they were then being very notable.
You can’t view either stocks or bonds in isolation, apart from the influence of their markets, the trading of stocks and bonds where we reach price discovery not due to someone’s theoretical view of economics, but what people are willing to pay for these things. The major bull market with treasuries that we saw come to an end lately is actually due to all the increased demand for U.S. treasuries that we saw during this time, nothing more and nothing less.
When we seek to gain the correct view of how either stocks or bonds may move, we cannot do so by trying to divorce ourselves from the event itself. Economics may tell us many things about these markets but the most fundamental of these is that prices are determined by supply and demand, and solely so.
Expert bond traders understand the role of the market in bond prices because they actually focus on the market, much like expert stock traders focus on the changing trends in supply and demand with stocks. While others may seek to impose their beliefs about where this supply and demand will take us and take their eye off the ball in favor of their predictions, traders understand that they are in it to predict price movement and market dynamics are the only real thing to look at.
For instance, during this bond rally, we went through a period where demand increased. This isn’t speculation, as we know this with certainty by just looking at the charts. While people are free to speculate as to where these markets may be headed, based upon external conditions aside from the market itself, fundamental analysis as they call it, we cannot ignore the fact that the demand itself is what ultimately moves these markets.
We got way out of line with treasury prices not due to these external factors, but more due to bond traders chasing prices. Just like people see stocks go up and want to get on the ride, this happens with the treasury market as well. Bond traders take advantage of high leverage and when you get stock-like returns like this, a lot of money is made by going long and multiplying these moves by a factor of 10.
Those who approach this from the perspective of the investor, including people paid very well to advise investors, somehow miss out on a lot of this, not even calculating in the effect of momentum. Everything in their world is hidden in the fundamental data they think, even though there may not be a good explanation why prices rise so much versus their normal economic calculations.
Even as we hit these record low yields, there were many calling for it to go even lower, and this was at a time where the economy was in a crisis. However, there are limits to what people are willing to spend on treasuries, especially with such little upside and such a big downside.
These people also wish to understand the movement of bond prices in terms of desired yield, which totally ignores market effects as well as other reasons to trade bonds, to seek capital gains. This is like trying to understand stocks by looking at dividends, conveniently and foolishly forgetting that capital gains is the major force that drives future value. We cannot play the market very well by trying to ignore it. The outlook for bonds on this basis has been poor for quite a while, and it all has to do with market trends.
While we shared these concerns with our readers, explaining how terrible treasuries were back then, after their prices topped, investors grumbled at how low the yields they were getting, and thought that was the downside of the play, not being aware of how much risk that they were taking on.
The real reason why prices are really dropping now, and yields climbing in turn, as been the fact that the market became so saturated to tip the scales enough for profit taking to kick in. You won’t hear these fundamentalists speak of such things because they do not even seem aware of the impact of the bond market on the bond market, or that people do anything but buy these things and reap the interest payments over many years.
The momentum in the treasury market over the last 4 months has been decidedly negative, and while the economy recovering at least some of the way might be thought to be the main driver, in reality, this comes down to one single thing, the waning reluctance of people to pay as much as they did for these debt instruments.
These fundamentalists understand the value of stocks as if they owned private shares, where you own a piece of the value of a company, and the value of the company is determined fundamentally. Public trading takes this value and transforms it into speculative value, not partly but completely, leaving the fundamentalists looking at the wrong things.
We Need to Know How Our Investments Work
The same happens when you trade anything, including treasuries. The difference is that fundamentalists see value as the retail price of something at a store, when it is instead sold at an auction. People pay millions for paintings worth only a few dollars, and it is the willingness to pay that sets their prices, not what it cost to make the thing plus a reasonable profit.
Investors view stocks dynamically, meaning that the goal on the long side is clearly to see the price of the stock increase, but somehow miss that this also goes on with bonds. They don’t even look at prices themselves, they instead focus on yields, and that can serve just as well provided that you understand the dynamic nature of the value of bonds and don’t just see them statically, buying a certain yield based upon the price at the time.
If you bought the 10 year back when it had a yield around 0.6%, and you see this yield a full 50 basis points higher today, you might be thinking that you should have waited to get a better yield, and while that may be true, you miss how much money this has really cost you since your bonds are worth considerably less now.
If your friend just bought this with a yield of 1.1%, both of you might think that this turned out to be a wise move, until you consider where the trend is with this. As yields rise when you are holding bonds, you lose money proportionately. If yields are expected to rise, and you invest anyway, you are investing to lose.
When it comes to comparing the desirability of stocks versus bonds, there is more going on here than comparing gains in stock prices versus treasury yields, especially since there is an inverse relationship between yields and prices. Yields don’t even make it into this calculation, as we need to look at how the value of investments change over time, and your interest payment versus what you paid for the thing in the past or even now just isn’t relevant.
To really muddy this relationship up, fundamentalists like to compare current yields with earnings with companies whose stocks are traded, which really takes us far off the road and into the woods since the value of stocks and the earnings of the companies that issue the stock are two separate things.
The fact that we see such a wide divergence between stock valuations based on earnings should settle the issue with certainty, unless you are a true believer and just refuse to admit you are wrong. There are many true believers.
We know that there is a bearish trend underway with treasuries, and as is always the case with asset prices, there are many influencers. Going from a dreadful economic state to the more promise that is ahead will influence some people to take their money out of bonds , as will the trend itself, as will the expectation of more stimulus now that the spend happy Democrats have now run the table.
Inflation is on the way, to be sure, it’s just a matter of how soon and how much. As inflation rises, this takes away people’s desire to own debt instruments, and depresses prices. It’s important to realize that this is caused by a reduction in demand, not some invisible hand that reaches out of the sky when it sees inflation on the horizon and pushes down treasury prices with its mighty hand.
The fact that we’re in for this does form a significant part of our being bearish about bonds for quite a while now, but this is not the only thing to look at. A rising stock market is generally a negative influencer for bonds, where money is moved between the markets and stocks doing better will cause the demand for stocks to rise, and a lot of bond money hears this call and changes horses.
Misunderstanding About Bonds Abounds Among Investors
The way investors view bonds is hideously distorted, not even having a semblance of the nature of these investments, and even at times rooting for yields to go up while they hold them, perhaps even serving to whet their appetite to buy more, not knowing they are wrestling with bears.
It therefore takes a lot to grab our attention, things that stand out in this sea of confusion enough to notice, but Albert Edwards of Societe Generale telling us that the 10 year yield going above 1% looks like the tipping point for stocks really shows how confused these things can get.
This downward trend in treasuries is, if anything, bullish for stocks, as this money does need to be placed elsewhere, and stocks get their share of this money that is no longer in treasuries and needs to go somewhere else. If demand for stocks goes up, this has a positive effect on their prices, so seeing the yield rise above 1% would be a good thing to see if you owned stocks, if anything.
There’s a lot more that moves stock prices besides this but this is at least an influencer worth paying attention to, but we have to get the direction of influence right. We may wonder what scheme of reasoning would claim the opposite, and this is where the real confusion comes out.
Edwards does realize that all the money that the Fed is putting into bonds these days won’t be enough to keep prices up, but how this may be expected to affect stock prices, or what this even has to do with them other than to drive them up at least somewhat, is left unexplained.
This view is actually based upon the idea that the gap between the 10 year yield and the average earnings growth of the S&P 500 means something, and once again, we’re left completely in the dark about why this means anything, let alone be a way to predict future stock prices.
The theory is that when the difference between the two exceed 3%, right around where it sits now, this is somehow bad for stocks. We might wonder what the mechanism of influence is with this theory, but these things need no explanation, they just assume treasuries are risk-free and measure the difference as the magical risk premium that we don’t want to go below 3% presumably.
It doesn’t even matter if this is a valid observation, and it isn’t anyway because these things have nothing to do with each other, we still have to connect rising yields with this. This doesn’t even measure the right thing, as it focuses on changes in earnings growth instead of price growth with stocks, and these aren’t not only not the same thing, they are poorly correlated.
What’s worse is that rising yields forecast inflation, and stocks love inflation as it turns out, at least in terms of nominal value. Inflation itself puts stocks up, all other things being equal, because if nothing else influences a stock’s price, inflation will make stock prices nominally higher by that amount, worth the same in real money but we use nominal value to measure stock prices.
The risk with higher inflation and stock prices is that this causes central banks to reduce money supply to look to curb inflation, and when this happens, stocks stand up and pay attention, but not before, and certainly not during a time of such epic monetary expansionism.
With the Fed telling us that they do not plan to contract the money supply anytime soon, the coast is clear on this front anyway. There are more fronts, but this is the one that matters the most, and is the reason why the stock market has shrugged off a hideous collection of negative influencers in 2020 and remains solidly moving ahead in spite of it all.
The inflation will come soon enough, although it is not on the horizon right now and investors who worry about this simply do not understand. This is especially true among those who think rising treasury yields are not only bearish for stocks but portend a tipping point, with nothing but the belief to support this.
If people are looking to cash in on the current trend with treasuries, and don’t mind hanging on to them for a couple of years, at least while the prodigal Democrats rule the roost completely, putting money in an inverse bond ETF at least looks to take advantage of the trend rather than to buck it and very likely get bucked around.
So many people invest in bonds, even putting half of their future or more on them, and could really benefit from at least understand that this is not just a one way street, where you pay a particular price for riding the bear markets and getting injured by it, rather than running with the bears by being in inverse funds when yields are expected to rise, and confine their bull riding to when yields are going down.
It’s not that bond allocations are all that exciting, and do not come close to the returns that stocks offer, but if you do need to be in bonds all the time, it is at least worth being on the right side of them, when they are going up in value instead of going down, where you can change over to making money when yields go up by going inverse. There is no up or down essentially with bonds, but there is right or wrong.
As for stocks, we need to pay attention to stocks not bonds, and if we see bond prices going down as yields rise, this means less money in bonds and more that can be invested in our stocks, increasing the demand for them. It’s not hard to follow the action, you just need to watch, and preferably, not by using cracked crystal balls but instead with the clean and direct view that looking at the stock market itself and its trends provides.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
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