Why does it seem like bond yields are far ahead of the stock market? Why do yields rise before equity traders start to get worried? Are they really that much smarter than we are? What information do they have that we do not? As it turns out, they may be working with the same information that we have.
What is it About the Bond Market?
A graph comparing the year over year change in high yield option adjusted bond yields and the S&P shows an interesting connection. Bond yields tend to spike before the S&P sees decreases in value. In blue I have plotted the percent change in inverse bond yields (that is, when the blue line goes negative, bond yields have risen) and in red I plotted the percent change in the nominal S&P 500 index. The nominal numbers on the y-axis are irrelevant due to the manipulations, but the magnitude of the results are important.
We see what happens during a broad stock market crash. First, in blue, bond yields spike. Soon thereafter the stock market follows suit and itself also crashes. This effect is very striking in 2007, when bond yields spiked for a while before the S&P noticed anything. This also works in reverse, as in 2009 bond yields finally started falling, and the S&P quickly caught up. The same phenomenon happened in 2011 when bond yields rose, and the stock market later followed and tapered, though this was not a large correction, and both seemed to correct around the same time in 2012.
What is fascinating is what is happening in the bond market today. Since the middle of 2014 high yield bond yields have been rising, and gains in the stock market seem to have slowed. If the bond market is correct as it was in 2007, then the stock market is due for major problems. This increase in yields, though, demands scrutiny. What is causing it? Is this trend sustainable? Will it definitely cause the overall stock market to also dip?
What Does the Bond Market Know that Equity Traders do not?
Before answering the question about whether the stock market will be impacted, it is worth asking what has caused bond yields to rise. A look at two price indices should show all of the explanation that is necessary.
In 2006, the housing bubble began to slow in earnest, as year over year price declines manifested themselves in housing (green). In addition, weakness in oil prices also popped up (red). Note the trend. Both housing and oil dipped before yields started to rise. What bond traders were responding to were the fundamental changes in the housing and energy sectors.
Notice also when bond yields started to correct: exactly when the inflection in both housing and oil took hold. Then and only then did yields finally start to gain momentum, finally decreasing in yield about the time that oil also started seeing price gains.
In 2014, a very similar trend has appeared. Oil started seeing year over year price declines, while bond yields quickly followed suit and started rising. On top of that, weakness has appeared in home prices, which may also contribute to a rise in yields. What this appears to be is a reversal of what happened in 2007. Instead of housing first causing the rise in yields and then oil keeping them high, what seems to be happening now is that oil is now causing the spike in yields, and housing may soon follow to keep them high.
So yes, based on past events, it does seem as though this rise in bond yields is sustainable, and if it is sustainable, then it will likely impact the stock market soon as well.
How Similar Does Yesterday Look to Today?
This is what it looked like before the last major market correction. The S&P and high yield credit show a tight relationship, bond yields spiked, and the S&P denied it, but it eventually caught down to yields.
And this is what it looks like today. Yields are spiking, and the S&P has still not responded. We have visual similarity, and the fundamentals are also lining up quite nicely.
Ultimately someone is going to be wrong, and if history is any indicator, then the S&P has some serious pain in store.
Summary and Action to Take
The rise in yields that has occurred in the high yield market over the past months has been sustainable and has been nothing more than a response to market fundamentals. The bond market reacts quickly and swiftly to deteriorating market conditions. What we see today is very similar to what we saw in 2007. Today, oil prices are pushing bond yields up, and have corrected to such an extent that it is portending a serious market correction. The stock market, much like in 2007, has been oblivious to this and has not seen any serious selloff. The bond market is not irrational, and yields have spiked for good reason.
Correspondingly, now would seem like an excellent time to steer clear of both stocks and bonds. For the speculative among us, this is a great opportunity to initiate a short of both the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) and the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG). Other than that, try to load up on some resources to invest in a few years, because there a sure to be more than a few bargains once the stock market dips.
Disclosure: The author is short HYG.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.