What is the bond market telling us?
In two weeks, the Fed will hike interest rates by another 75bp. Stocks and bonds have sold off due to the restrictive monetary policies. Stocks have declined precipitously, and rates have soared. There is no place for investors to hide.
So, what does this all mean for investors and the financial markets?
Historically, bonds tend to move ahead of stock prices, and stocks rise or fall before pivotal turns in economic conditions. Astute and experienced investors will look to the bond and credit markets for guidance on the state of the economy and financial markets.
Not all bonds move in the same way when interest rates rise sharply. Short-term bonds are less sensitive to volatile moves in rates as compared to longer-term bonds, suggesting potential buying opportunities for conservative income investors.
Corporate and high-yield bonds can also offer insights into financial market conditions. The spreads between treasury bond maturities, high yield, and investment-grade corporate bonds are equally important. Recently, interest rates have fallen, but credit spreads have also contracted.
Does this imply an impending recession?
Or has inflation peaked?
New CPI and economic numbers will come out soon. Inflation shows no signs of abating. Investors continue to fear the Fed’s hikes can lead to a hard landing and an economic recession toward the end of the year or early next year.
Since more Fed rate hikes are in store, short-term rates have climbed sharply higher over the short timeframe. For example, the two-year Treasury yield has exceeded the 10-year yield for the second time in the past year. The first yield curve inversion occurred in early April 2022.
Are the second inversion additional signs that bond investors are increasingly concerned about a slowing economy and a recession?
The current spread between corporate, junk bonds, and US treasuries is around 4 to 5 percentage points. It is high on a near-term basis but not unusual from a historical perspective. Nonetheless, if this trend continues, it signals deteriorating credit conditions and a weakening economy.
Is the 10-year treasury yield (TNX) peaking, at least on a near-term basis, as evidenced by a potential head and shoulders top?
A 3-month near-term top has developed in TNX. Neckline support is 2.708-2.746% (May and Jul 2022 lows), the head is 3.483% (Jun 2022 high), and left/right shoulders are 3.101-3.167% (May and Jul 2022 highs).
A confirmed breakdown below 2.708% hints at 0.775% or a downside target at 1.933%. Intermediate-term support converges near 2.03-2.14%, coinciding with the Mar 2022 high, Aug 2020 uptrend, and 200-day ma.
Given the sharp rally in interest rates over the past year, it is reasonable to expect an overbought condition leads to consolidation. However, if TNX violates 1.9-2.0%, does this imply interest rates have peaked and headed lower?
Treasury bonds are safer than investment-grade bonds, which offer less risk than high-yield or junk bonds. Interestingly, it is unusual for investment-grade corporates (LQD) to outperform high-yield corporates (JNK) based on the lower risk.
Although yields and returns between two bonds are crucial to bond investors, credit quality is equally important. Junk bonds are riskier investments and hence have a higher risk of default. Investors demand a higher rate of return for junk bonds in relationship to investment-grade corporates and US treasuries.
The underperformance of high-yield bonds relative to investment-grade corporates is noteworthy. It would imply bond investors may be pricing in a higher probability of defaults or deteriorating economic conditions in the future.
If the above trends continue, it can lead to further selling in the stock market, as investors continue to liquidate stocks and move to the safety of higher quality and safer bond investments, especially when two-year treasuries offer yields at 3.07%.