The big story this morning is that Treasury yields continue their grind higher - this despite the strong 30 Year auction last week which many expected had put a bottom on bond prices at least for the short-term. As can be seen on the attached chart, the 10 Year has resumed its drift lower, with yields once again touching multi-month highs, not to mention the 10s30s continue to flatten and is about to hit 100 bps. The move prompted an early wake up call for David Ader, head of government bond strategy at CRT who sent out the following note earlier: "Just when we thought it was safe to say something nice about the market, we get a sharp move lower (alas in price, not yield) in an active overnight session. We say active as volumes were 114% of the average, but to be sure it’s harder to find a new reason for the weakness other than the price action itself. Thus we’ll caution that the weakness is in part a function of liquidity and fear." There are two schools of thought as to what is causing the gap lower: i) the realization by various bondholders that nobody is concerned about US funding levels and that the next target of the bond vigilantes will be the US itself, and ii) that courtesy of the latest round of fiscal stimulus, the economy may have bought itself a short-term bounce and it is time to fade the deflationary move in bonds which was the prevalent trade of 2010. Either way, the inflationary threat is now all too real, and with rates jumping and mortgages surging, it is difficult to envision a nascent recovery in which the prevailing price of housing just dropped yet again courtesy of higher rates. So what does this mean for stocks? Once again, courtesy of some historical perspectives by Sentiment Trader, we look at what happened in the past to stock prices when bond yields started a gap move wider.
April 23, 1971:
In the spring of '71, yields rose quickly from their March low. By late April, they had risen more than 10%, but the S&P 500 was still hitting new 52-week highs on an almost daily basis. That stopped immediately, and equities went into a deep seven-month correction.
May 27, 1986
In 1986, yields jumped quickly and severely from their April low. The bounce was short-lived, but traders didn't know that at the time. When the S&P hit a high in late May, it quickly pulled back, thrust back up to a marginal new high, then fall into a four-month sideways correction before resuming an impressive rally.
November 27, 1992
This time the run-up in yields, and stock prices, didn't end so well. The S&P immediately fell back from its 52-week high, then jumped higher in a quick spasm, putting in a formation on the chart that looks like the S&P was giving everyone the finger. That next spike was the end of the bull run, and the S&P started to slip precipitously. During March of 1994, it crashed nearly 7% over a period of just a couple of weeks as yields continued to shoot higher.
November 23, 1998:
Once again this time, a new high in the S&P, after yields had already risen at least 10%, led to a short-term correction. Stocks pulled back for about three weeks, then shot higher and made new highs once again. After that, the S&P went into a two-month trading range, before breaking out and making its final bull run of the miraculous 1990's bull market.
September 2, 2003:
After the 2000 - 2002 bear market ended, bond yields bottomed after stocks did. By early September 2003, the S&P was making one-year highs, and yields by that time had rallied substantially from their lows. The S&P went into a multi-week correction, but that was erased quickly in an early October rally. Stocks never really looked back until the January 2004 peak.
August 2, 2005:
The last occurrence was more than five years ago. This time, stocks once again fell into a correction immediately, but unlike the last couple of times the initial decline wasn't made up right away. Stocks continued to decline for about two months, with the S&P suffering a loss of about 75 points. Coincidentally, that 75-point correction began with the S&P at almost exactly the same level it closed at on Friday.
So no major surprises: with one exception, the market tends to run into a bond hike, only to realize that such moves end up being driven by permissive monetary policy and rarely by actual economic moves (assuming fundamentals news is even remotely relevant to market formation... the alternative of course would finally put an end the seemingly endless fallacies spewed forth by every Chicago school of thought). And unlike now, at least in the past the US was not saddled with an amount of debt that on a gross basis is substantially greater than GDP. Sooner or later the market will finally need to come to grips with the realization that it is the jump in yields that is the black swan, nothing more and nothing less. At a time of record deficits, when the Fed will soon own over $1 trillion in Treasurys, the smallest marginal moves on rates will have a disastrous impact on what is already an unsustainable deficit. Add to this the fact that we now anticipate that the debt ceiling will have to be raised not once but twice in 2011, and we, just like everyone else who is not a sellside Koolaid peddler, are scratching our heads as to just how it is possible that stocks continue to show the kind of dogged momentum chasing determination that virtually every buysider realizes will sooner or later end in tears.