Bonds Tell The Real Tale For U.S. Economy

Summary

• Bond market doesn't share stock market's concern over U.S.-China.
• Municipal bonds in particular are reflecting a strong economic outlook.
• High-quality corporate debt market points to bullish financial conditions.

Fear returned to the financial market this week as investors worried that a March 1 trade deadline for the U.S. and China wouldn’t be met. This resulted in a spike in stock market volatility and a pullback in the major U.S. averages. While many participants fear a worst-case scenario, the bond market is sending a bullish message for the financial market outlook. We’ll take a look at these positive aspects in today’s commentary.

After Thursday’s stock market slide based on renewed trade tariff fears, investors were left wondering if another major plunge in the S&P 500 Index (SPX) is in the offing. This was nowhere more evident than in the 6.44% jump in the CBOE Volatility Index (VIX), which is Wall Street’s favorite fear gauge. Are investors correct to worry about the integrity of the stock market’s recovery since the Dec. 24 bottom in the SPX? And will the U.S.-China trade dispute result in a weakened global economy? As I’ll explain, both these questions can be answered in the negative.

One reason for not fearing a worst-case scenario for the U.S. is the bond market, including government, corporate and municipal bonds. All three aspects of the market are reflecting calmness and a conspicuous lack of concern about the intermediate-term (3-9 month) outlook. The CBOE 10-Year Treasury Note Yield Index (TNX) is a good place to start, since this reflects the prevailing interest rate trend. As can be seen in the graph below, TNX remains far below its October peak and shows that interest rate pressures aren’t a concern among traders right now.

Source: BigCharts

The 10-year Treasury yield is an extremely important factor to consider when evaluating the equity market and economic outlooks. It can be argued that interest rates have in fact been the primary concern of investors since last year. The rally in Treasury bond yields last summer greatly contributed to the stock market’s weakness in late 2018, for the rising rate environment resulted in heavy and sustained liquidation of muni-bond funds, real estate equities and other rate-sensitive securities. This liquidation began last September and didn’t end until the end of December. It was plainly evident in the huge number of rate-sensitive stocks and funds which showed up on a daily basis on the NYSE new 52-week lows list during those months.

The rising trend in bond yields was in part a result of the market’s fears that the Federal Reserve’s interest rate policy was too tight given the slowdown in the global economy. When the Fed recently made it clear that it would listen to the market and likely stop raising its benchmark rate, this was all the assurance investors needed to stop liquidating stocks and bonds. Since that time, not only have yields on government and corporate bonds come down significantly, but equity prices have also rallied in response to the big improvement in financial market liquidity.

As if a cessation of rising rates wasn’t enough to assure the market of the Fed’s benevolent intentions, there are many Fed watchers who now believe the bank’s next move could actually be a rate cut. According to former Fed Chair Janet Yellen, the Fed may cut its benchmark rate, especially if the global economy shows any signs of weakening in the coming months. Regardless of whether the Fed actually carries out this action, the mere enunciation of a return to an accommodative monetary policy stance has given renewed confidence to the bond market.

Another area of the market which is reflecting a strong measure of confidence is corporate bonds. The outlook for corporate profits is getting stronger, as the rising trend in investment quality bonds shows. Below is a graph of the recent trend in the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). This proxy for high-quality corporate debt recently hit its highest level since last April as profit outlook for corporations rises, thanks in part to the Fed’s more lenient rate policy.

Source: BigCharts

It should be added that corporate bonds can also be used as a leading indicator for the stock market. Historically, a sustained rising trend in blue-chip corporate bonds has been followed by rising stock prices in the months to follow since the corporate bond market trend is largely dominated by informed investors (as opposed to small-time retail traders). These investors are evidently optimistic about U.S. growth potential in the coming months. The rising trend in LQD is thus another reason why investors should not be overly concerned by the revival of trade war fears.

Perhaps even more so than corporate bonds, the real tale for the U.S. economy and financial market outlook is visible in the market for municipal bonds. Keeping in mind that last year’s (legitimate) fears over the potential negative impact of higher interest rates was reflected heavily in municipal bond prices. The big sell-off in muni-bonds and muni-bond funds last summer gave advance warning that the overall U.S. equity market outlook was in danger. This proved to be prescient as the stock market plunged just a few weeks later.

The following chart exhibits the remarkable V-shaped recovery in muni-bond prices since last November. The 6-month progression of the iShares National Muni Bond ETF (MUB) shows not only the leading sell signal which muni-bonds gave for the stock market last September, but also the “heads up” bottom signal for stocks in November. Municipal bonds are an even more sensitive leading indicator to shifts in the intermediate-term financial market winds than corporate bonds.

Source: BigCharts

With municipal bonds, corporate bonds, and government bonds all reflecting confidence in the economic and corporate profit outlook, investors are justified in ignoring the latest news-related volatility. Instead of panicking over developments in the U.S.-China trade tariff dispute, participants should focus on the promising signs which point to higher prices for stocks and corporate bonds in the coming months. As long as the Fed remains true to its word to listen to the market and hold off on raising the Fed Funds rate, bonds should continue to benefit.

Investors can profit from this favorable climate by having some exposure to investment-grade corporate bonds, as well as the shares of fundamentally strong companies in outperforming sectors (e.g. consumer staples, financials, and techs). Investors can also maintain a conservative long position in the Vanguard Short-Term Corporate Bond ETF as mentioned in previous reports.

Analyst’s Disclosure: I am/we are long SPHQ, IAU, VCSH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.