Bond Yield Breakout

Here’s a general gist of the headlines over the past week or two…

Global capital is flowing out of emerging markets. Bond prices in this sector are falling (meaning yields are rising) along with currencies and equity markets.

Argentina has had to jack interest rates up to 40% to protect its currency, and then they still had to bring in the IMF for a bailout package. Once again, this South American economy is in shambles.

Italy is finally organising a semblance of a government after months of post-election uncertainty. The newly forming coalition government is a populist one, and anti-euro. And their platform might just be a little unrealistic. As Reuters puts it:

ROME (Reuters) — The Italian coalition taking shape 10 weeks after March’s inconclusive election has made economic promises that seem incompatible with Europe’s fiscal rules and will be hard, if not impossible, to keep.

The fact that US and European markets advanced strongly during these concerning developments tells you one of two things: that they are all minor events and issues with no real bearing on a global scale, or that investor sentiment is still positive enough to disregard and ‘look through’ worrying economic and political developments.

Which is it?

I don’t have a clue.

But as the saying goes, markets make opinions, so on that basis the bulls are still in charge. Despite the global equity market sell-off and associated volatility since late January, the major US indices haven’t broken down into what you would call bear market territory just yet.

Recent first quarter corporate earnings reports in the US were good enough to spark this recent rally. And the lack of trade war talk has kept investor sentiment positive.

That has contributed to the S&P 500 looking like this:

Optuma Chart 2018-05-15

Source: Optuma

[Click to open new window]

Since 3 May, the S&P 500 has rallied strongly and away from crucial support around 2,580 points. If the index broke below the lows from March and February, it would increase the chances that the most important index in the world was heading into a bear market.

But that outcome has not eventuated. At least, not yet.

Still, that doesn’t mean it’s all rainbows and lollipops. At best, the market is in a large consolidation pattern. While we’re conditioned to think in terms of bull or bear markets, it doesn’t always play out like that.

Markets can spend long periods of time in a sideways trading range, while investors work out which way to go. 

I think this is the case now. Investors are genuinely confused as to whether January was a longer term top (end of a bull market, start of a bear) or the start of a more benign longer term correction and consolidation pattern.

And it could continue to result in a few more months of indecisive trading. As I mentioned, corporate earnings are very healthy. The only question is whether earnings growth has peaked.

On the bear side, upward pressure remains on interest rates. And with oil prices at four year highs, it’s only a matter of time before inflation starts to worry central bankers.

Looking at the 10-year US Treasury yield chart, below, you can see that yields are clearly trending higher.

Optuma Chart 2 2018-05-15

Source: Optuma

[Click to open new window]

On 25 April, yields briefly punched through 3% before selling off. Given the oil price trajectory, and the tightness of the labour market, it seems highly probable that yields will breach 3% and keep moving north in the months ahead.

The thing is, as you can see from the longer term chart of the 10-year Treasury yield, below, the 3% level is important. As in, if it breaks higher, yields will likely surge in a short space of time.

Optuma Chart 3 2018-05-15

Source: Optuma

[Click to open new window]

Now, given the prior surge in bond yields (at the start of 2018) resulted in a minor stock market heart attack, I’m guessing the market won’t be overly impressed should yields shoot higher again.

The other outcome is that we head back to an Alice in Wonderland world where a negative economic shock sends yields sharply lower, on expectations of weaker growth and few to no interest rate rises. In such an environment, the stock market could rally on the prospect of renewed stimulus.

Admittedly, that’s a long shot. But in a market desperate not to give up its reliance on stimulus (be it fiscal or monetary) it’s not entirely absurd.

My guess is that the benchmark US bond yield will eventually break higher. While that might not lead to a full on bear market, it’s hard to see how stock prices will react positively to such a move.

So for now, it’s all eyes on the US 10-year bond yield.


Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

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Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

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