Are Bond Yields Sending a Warning Signal to Stocks?

As Treasuries rally (the 10-year yield has gone from 1.63% to 1.45% in less than two weeks), there is some chatter that lower rates should be treated as a warning sign that the economy is about to slow down. While that is often the case, I think this time is different. It is always dangerous to argue that this time is different but I have several reasons for thinking that way. It's a Global Event Bonds in Germany and the U.K. also rallied. Commodity-linked economies such as Australia and Canada also saw their bond yields drop significantly. In theory this could be a harbinger of a global economic slowdown, but I don't think so. In any case, it is important to note that this was global and not just a domestic issue. Credit Participated Too When looking at bond yields, it is useful to look at risk-free rates, but also to look at those bonds that have credit risk. Italian bonds rallied more than German bunds. Corporate debt spreads tightened during this period. In a risk-off move, like we had in March 2020, we would expect to see spreads widen. That gives me comfort. The Chase for Yield Is Evident The Federal Reserve has an overnight repo facility that grew from $200 billion in mid-May to over $500 billion last week. This is investors who do not want to buy T-bills at negative yields (T-bills have negative yields out to one month). I view the massive increase in use of this facility as a sign of how little yield there is available. So, while some short-term investors gravitate to this facility, I suspect that investors of all types are being forced to buy longer-dated bonds than they would otherwise, or to take on more credit risk than they would otherwise. This chase for yield had a lot to do with the move. The Short Squeeze? I am not sure whether this move was driven by a short squeeze or by a new buyer. In the end, it doesn't make a difference, but the short-squeeze narrative doesn't match what I'm hearing from many large trading firms, what we see in ETF flows (like iShares 20+ Year Treasury Bond ETF ) and even the futures Commitment of Trader reports. In any case, positioning is much more balanced after last week. Don't Get Fooled by Commodities Commodity prices are dropping, but: Commodity inflation is almost always transitory (and longer-dated futures never had the same froth that the front futures contracts did, though it is the front futures contracts, that are widely published and reported on). Higher commodity prices are starting to act as a headwind, especially in the housing market. Easing back a bit allows the economic expansion to continue more easily. Wage Inflation The JOLT report had the largest number of unfilled jobs on record. I can go on and on about jobs, and I have in the past, but look for wage inflation. Companies Can and Are Passing on Costs Costs are rising for the consumer across all sectors and services. I see no reason for that not to continue. I think the commodity inflation was transitory, but real, long and lasting inflation is coming, as part of a robust period of economic growth. Bottom Line I believe the move to lower yields is transitory but stocks as a whole are well positioned to shrug off any move to higher yields. If anything, if yields continue to go lower, the global economic slowdown narrative, which I currently do not believe in, could get more traction. That would be negative for stocks and credit products, especially high-yield bonds.

Are Bond Yields Sending a Warning Signal to Stocks?

Whether this move was driven by a short squeeze or by a new buyer, in the end, it doesn't make a difference.

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