Bonds Behaving Badly (Again) -- Here's Why

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Harry Truman once famously begged for a one-handed economist, so they could not say "on the other hand..."

Qualifying every statement is, however, a necessary evil in economics, and also in trading. Everything I was ever taught about the way markets work came with pretty much the same caveat; something along the lines of, "...of course, it doesn’t apply all the time."

That is important for traders and investors to remember, as belief in the infallibility of a system or signal is one of the most dangerous traits to develop. Once you accept that, looking at why certain "rules" have been broken can give a lot of insight into market moves.

There is, for example, a well-known inverse relationship between bonds and stocks. The theory is that most investors constantly choose between the relative safety of bonds and a riskier investment in stocks. If things look good, they buy stocks; if there is fear or doubt, they move into bonds.

Thus, when stock prices rise, bond prices fall and vice versa.

That relationship forms the basis of modern portfolio theory. When it holds, owning a mix of stocks and bonds smooths out the volatility inherent in markets and gives the investor some degree of protection. It is so well established and widely recognized that when it completely breaks down, as it has recently, it is obviously significant.

Any talk about bonds is complicated by the way they are usually measured. Investment decisions regarding bonds of any kind are not usually made based on price, but on yield, the percentage interest one can expect to receive while holding the investment.

At issuance, most bonds have what is called a “coupon” which is a fixed percentage of the face value that is paid to holders each year. If, for example a bond was initially sold for $100 with a 5% coupon, the holder would be paid $5 a year for as long as they held the bond or until it matures, when they get their $100 back.

That $5 amount doesn’t change, so to reflect changes in prevailing interest rates the price of the bond moves. If, for example, prevailing interest rates fall to 2.5%, the price of the bond would rise to $200 so that the $5 interest paid would reflect that 2.5%. It is not quite that simple, because the time until repayment is factored in, but that is the basic idea.

It follows, then, that if the relationship between bond and stock prices holds, bond yields move in the same direction as stocks. When stocks go up, bond prices fall so yields rise. Recently, however, that hasn’t been the case.

The charts above are for the S&P 500 (top) and the yield on the benchmark 10-Year Treasury Note (bottom). As you can see, at the end of last year, when stocks dropped, yields followed them lower as would be expected. So far this year though, as stocks have recovered, 10-Year yields have remained stubbornly low. The question for investors is why that has happened.

The obvious conclusion is that the bond market, which is usually the more reliable predictor, is much more pessimistic about the future than the stock market. As mentioned above, however, there is always the “other hand” to be considered. In this case, that hand belongs to the Fed.

The extraordinary measures taken by the Fed since the recession have arguably been justified and helped enormously, but whatever you think of them, they have distorted the bond market. Treasury yields have become more about predicting moves by the FOMC than reflecting economic fundamentals, and that explains why they have remained depressed so far this year as the Fed has indicated that they might slow the pace of rate hikes.

That explains why bond yields have failed to bounce with stocks, but it isn’t the end of the story. There is also the question of why the Fed has changed course.

As Fed Chair Jerome Powell made clear in his 60 Minutes interview last night, they have not done so in response to political pressure, but because they believe there are real dangers to economic growth. That is a worry.

As Leuthold Group’s Jim Paulsen stated on CNBC on Friday, there are other things about the bond market that can be seen as positives for stocks, but I would be wary of his conclusion that that means all is well. The kind of distortion that we are seeing of a fundamental relationship can happen, but eventually order is always restored. Something has to give. Either bond yields have to go up or stocks have to go down and, given the Fed’s reasons for their actions, the latter looks more likely. 

Of course, on the other hand...

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Bonds , Central Bank , Investing Ideas , Stocks , US Markets

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