Bond Market Signaling Danger Ahead for StocksJuly 24th, 2012 by David Waring
By Rom Badilla, CFA and Chief Market Strategiest Bondsquawk.com
(July 2012) In the past two months, the stock market has posted strong gains that have given the bulls reason to run. Since the beginning of June, the S&P 500 has rallied almost 4% in a short amount of time. When you consider that the S&P 500 has appreciated only 0.9% on an annualized basis over the past 10 years (9.4% on a Total Return Basis from the beginning of 2002 through the end of 2011), this most recent gain is impressive indeed.
In similar fashion, the High Yield sector has gained. With investors searching for risk and reaching for yield from Speculative Grade Fixed Income securities, credit spreads have tightened. The credit spread of the Barclays’ High Yield Index which is the incremental yield over comparable U.S. Treasuries have compressed by 80 basis points in the past two months. As a source of context, it took the entire year in 2010 for the sector to tighten 91 basis points.
Judging by the numbers alone, you could argue that the headwinds that have plagued us before such as the European Debt Crisis and slowing economic growth are finally past us.
However, the bond market has been sending a completely different message, one that does not bode well for risk assets. Since the beginning of June, bonds have continued its onslaught by posting bigger gains as yields have been heading lower in a sign that market participants remain uneasy of concerns that the stock market has completely ignored.
From June 6 where the divergence between stocks and bonds first occurred, the yield on the 10-Year U.S. Treasury has declined almost 20 basis points from 1.66% to 1.44% as of last Friday (Chart Below, Top Section). During this time, the 10-Year in a flight-to-quality bid has challenged the all-time lows a number occasions and remains within spitting distance of surpassing it.
While the equity bulls could argue that yields are driven by current central bank intervention which in turn should drive stocks higher, the fact remains that there are other signs that justify the flight-to-quality bid in the 10-Year.
A dovish Federal Reserve with the objective of lowering short-term rates has usually led to a drop in the dollar as the central bank floods the system with liquidity and increases the money supply. However, during the recent run where the market has speculated that further monetary stimulus would be implemented to avert a slowdown in growth which would propel stock prices higher, the dollar has actually increased.
From the onset of the divergence between stocks and bonds, the U.S. dollar has appreciated as the Euro has tanked by 3.7% (Chart Above, Lower Section). In addition, the greenback’s rally isn’t just reserved against the crippled Euro. The Dollar Index which is a measure of value against five major currencies in addition to the Euro has gained 1.6% to 83.68 which is the highest level in the past year.
When we take a step further back and look at the overall climate of the global economy, it is pretty easy to pinpoint the reasons as to why safety net assets like U.S. Treasuries and the Dollar are rallying.
Since the divergence, debt yields across the pond have been increasing, thereby setting off the alarm bells that the worst of the European Debt crisis is yet to come. Since the divergence, yields on Spanish borrowing costs have been soaring as the yield on the 10-Year has spiked almost a 100 basis points to 7.27%. Borrowing costs above seven percent may lead many market participants to conclude that sovereign debt levels are unsustainable and are likely to spiral out of control which in turn, could lead to a bailout ultimately. This fate was shared by other smaller peripherals such as Greece, Ireland, and Portugal whose borrowing costs soared in the last several years.
While it has yet to reach that threshold, Italy’s long-term debt yields have been escalating as well. The yield on the 10-Year Italian benchmark note has increased 50 basis points to 6.17% since the beginning of June.
Closer to home, U.S. economic data has added to the uncertainty suggesting increasing risks for a double dip. While the Unemployment Data remains stubbornly high and continues to be thorn in politicians’ side in an election year, other economic indicators continue to disappoint.
The Citigroup U.S. Economic Surprise Index, which is an objective and quantitative measure of economic news and tracks the deviations from economists’ forecasts and actual releases, has sunk deeper in negative territory (Chart Below). The Citigroup Surprise Index for the U.S. Economy has fallen from -49.2 on June 6 to -64.5 set on Friday suggesting disappointment and slowing economic growth. A positive reading of the Economic Surprise Index suggests that economic releases have on balance beaten consensus.
Equities have had a good run in the last few months as evident by the performance of the S&P 500. The problem is that other asset classes such as Treasuries and the Dollar are hardly impressed and continue to reflect risks emanating both here and abroad. Given this, the recent run in the S&P 500 could appear corrective in a much larger intermediate downward trend. If this is indeed the case, this recent divergence between stocks and bond yields could be short-lived and a re-pricing of risk assets may be on the horizon.
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