By John Nyaradi
Bond market flashes warning signal to stocks and only one of these asset classes can be right.
As everyone knows, the bond market and the stock market tend to move inversely to each other. As stocks rise, bond prices fall and bond yields rise. As stock market prices fall, bond market prices rise and bond market yields falls.
This is simply a reflection of the flow of capital between “risk on” and “risk off” assets and tends to be reliable over long time frames. However, in today’s central bank influenced, Wizard of Oz economy, interesting divergences are now taking place between the bond market and the stock market.
Chart courtesy of StockCharts.com
In the chart above, its easy to see how 10 year bond yields and the S&P 500 tend to move in harmony. As the S&P 500 rises in price, bond yields tend to rise and as the S&P 500 falls in price, bond yields tend to fall and bond prices rise which is the natural flow of supply and demand in U.S. financial markets.
Now, however, we see a sharp divergence between these two asset classes as the S&P 500 continues to climb while the yield on the 10 year Treasury bond has entered a steep decline.
What this means is that the stock market as represented by the S&P 500 is bullish and continues to climb while the bond market is saying that money is migrating to the safety of bonds and so driving bond yields down and bond prices up. The bond market is saying that today’s environment is a “flight to quality” environment and that “risk on” assets are simply too risky.
A similar divergence occurred last May when bond yields started collapsing while the S&P 500 index held steady, but soon the S&P 500 followed with a decline of nearly 9% between early May and early June.
In the chart below, recent activity in iShares 7-10 Year Treasury Bond ETF (IEF) is depicted:
It’s glaringly apparent that bond prices have spiked in spite of recent record closes by the S&P 500 and Dow Jones Industrial Average.
This chart is not indicative of a confident market, by any means, as 10 year bond prices tend to spike in times of distress or uncertainty.
Bottom line: So now the question is, which market is right? Are stocks, as represented by the S&P 500 correct, or is the bond market, which is generally described as being the “smarter” of the two, correct in its assessment of current conditions. We’ll find out soon enough as, sooner or later, the bond market and the stock market will have to start listening to each other.
Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time.