One of the first articles I wrote when I started at Market Index was a little piece about how the bond market impacts the stock market. Ok, I know I lost you at bonds. “What the hell do I need to know about bonds”, you’re thinking!? An absolute snooze-fest – right?
Ok, I know bonds aren’t as exciting as iron ore, copper, uranium, rare earths, and lithium, but as I said in that first article, they are in my opinion “the biggest factor impacting your portfolio”. Today’s note is just a quick follow up to point out that movements in the bond market have played a critical role in the current rally – and that they will likely continue to do so (oh, and also, bonds really are exciting too!).
That first article was written nearly a couple of months ago when we were faced with a significantly more uncertain outlook for interest rates and the global economy. Fed rhetoric was firmly entrenched along the lines of “further rate hikes may be necessary to control inflation”.
A combination of better-than-expected US CPI data, along with a cooling in the labour market and inflation expectations, combined to turn expectations of what the Fed is likely to do in 2024 on their head. Let’s compare the most recent Fed move probabilities from 18 December to two months ago on 18 October.
The first thing which strikes you is all those zeros in the “HIKE” column! We went from a warm chance of a hike in 2024 to no chance, and from expectations of a prolonged hold, to the first cut potentially coming as soon as March (or May 2024).
Back to Bonds 101 for a second. Bonds are just like fancy term deposits. If the market expects interest rates are going to be higher in the future, locking your term deposit rate now isn’t such a good thing, and if you already have, you’d probably want to get rid of it in favour of one with a higher yield. In short, bonds are usually worth less when the market expects rates are going to rise.
The opposite is also true, and it’s exactly what happened in markets. In a very short space of time, the market has become absolutely convinced rates aren’t going any higher, and instead, they’re likely to go substantially lower. Bonds which had recently had very high yields, now look very juicy to long term investors seeking an attractive return. The bond market rocketed, and this forced market yields down.
Above is the chart of the yield of the US 30-year Treasury Bond (“T-Bond”). Note how much it has fallen since our last chat about bonds. This is a good thing if you have a mortgage in the US – as the 30-year T-bond is the key benchmark for US mortgage rates.
This is the key to appreciating why as an investor you should keep your eyes peeled on the bond market. Bond yields are the major factor in setting market rates. Not official rates, that’s the job of the Fed, the RBA & Co. Market rates are the rates companies earn and pay to each other, as well as the benchmark for investors trading in bonds and other fixed interest securities, as well as for us, eventually, with our mortgages.
Lower market rates are generally a massive win for stocks too. Many stocks use debt funding to grow their business meaning there’s a cost saving flowing from lower market rates, and lower market rates helps us spend more in the economy which in turn boosts company revenues. Investors also can pay more for stocks when market rates are lower because the opportunity cost of holding cash increases.
If you don’t believe me when I say lower market rates are good for stocks, check out what’s happened to the benchmark US stock index, the S&P 500, since bond yields peaked in October.
There’s plenty of talk at the moment that stocks, as usual, have overcooked expectations of interest rate cuts next year. Stock prices are too high, and therefore are ripe for a correction.
This may be the case, but it’s not showing up in the chart yet. There’s nothing in the S&P 500 chart which concerns me right now. Short and long term trends look robust, the price action is higher peaks and higher troughs – which is consistent with buy the dip, and candles are almost unanimously white over the last couple of months – which is a great indication of programmed buy orders seeping into a market with very little supply.
Before you get too excited, keep in mind I can’t tell the future! The next pullback, correction, or even bear market, could start today. What I can do is give you a few tips on what to watch out for in the technicals to help you spot if the current environment of excess demand has switched to excess supply.
Supply-Side Candles: Black bodies and/or upward pointing shadows (indication of programmed sell orders)
Price Sction: Lower peaks and lower troughs (indication of sell the rally activity)
Trend Change: Price closes below ST trend ribbon, ST trend ribbon turns amber (neutral trend) or pink (downtrend)
Points of Demand / Supply: Close below point of demand and/or point of demand subsequently acts as a point of supply
Looking back up at the 30-year T-Bond chart, I suggest we don’t want to see the 30-year T-Bond yield close back above the long term trend ribbon around 4.40%. I can see the potential for a short term increase in the 30-year T-Bond yield, however, to potentially test and probe back into the long term trend ribbon.
Such a move in yields could well translate into an imminent pullback/correction in the S&P 500, giving it a chance to probe, test and hold its ST uptrend ribbon. Such a pullback would be healthy to remove some of the speculative weak hands and confirm the long term money is still rock-solid on the dips. I’ll leave you with one final technical bug-out point for the S&P 500. I suggest that whilst it continues to close above 4,537 – this phase of the bull market remains intact.
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