A Scary Bond Chart and When We Need to Worry (Not Yet)

“Every 23rd spring, for 23 days, it gets to eat.”

We’ve reached the most deliciously creepy time of year, with ghouls, goblins, and beasties popping up around every corner.

If you’re not just a little scared of the Creeper in the “Jeepers Creepers” movies – an ancient creature that lies dormant for 23 years at a time, then resurfaces and tracks you down based on the scent of your fear – you’re not doing Halloween quite right.

In my opinion, the first “Creeper” movie is the best – and the slow-burning, evocative beginning, where a sinister truck follows two kids down empty twilight Florida roads, is the scariest part of all.

Even though nothing has happened yet…you just know it’s about to.

That’s why that “Every 23rd spring…” line gets you right in the gut. You’re safe right now, maybe…but not for long.

There’s a subtle difference between knowing something is scary and being afraid it will hurt or affect you right now — and we’re seeing that theme play out right now in the relationship between bonds and the stock market.

I’m about to show you a very frightening chart that we don’t have to worry about…yet.

But when we do, you’ll want to be prepared…

One Simple and One More Detailed Reason Bonds Are Affecting Stocks

Last week, I told you that even though interest rates have been in the news a bunch, it wasn’t really the rise in interest rates themselves that have the markets spooked. I introduced the concept of looking at difference between U.S. government treasury instruments that mature in 10 years and shorter-term ones that mature in in two years.

I also introduced you to the concept of a yield curve – and the idea that in a healthy economy, shorter term bonds should have a lower yield (pay less interest) than longer term ones.  The reason is two-fold: First, investors anticipate that economic growth will push inflation and therefore interest rates higher in the future.  Secondly, because investors have to hold onto longer-term bonds, there is risk of an economic hiccup that would keep higher rates from being realized, and so investors require a risk premium (a higher rate of return) to compensate for this possibility.

Over the last year or more, as the Fed has raised interest rates, the longer-term bonds have stubbornly inched up while the shorter-term bond rates have advanced quickly (as least quick for bonds).  This has led to a “flattened yield curve”.

Why is this a problem? When the rates for the short and long maturity bonds are nearly the same, it means that investors are concerned that economic expansion can’t be sustained and won’t be able to support higher interest rates in the future.

And that leads to a more important point for today’s market – there’s a third type of yield curve called an inverted yield curve, where short-term yields are higher than long-term yields.  Economically, this means that prognosis for growth is bad.  For the markets, an inverted yield curve has been a signal for “recession ahead”. It’s the prospect of the dreaded yellow curve in the chart below that has the markets on edge right now:

With that background re-visited, let’s dig into two things.  The first is why I don’t think the recent move up in rates is the real problem, and then move onto the scary chart that gives me reason to believe that the relationship between short and long maturity treasuries is the real reason the market has been pulling back.

Is a 0.25% rise (what bond people call a 25 basis point rise) in 10-year treasury rates the real problem?  Here’s the chart that makes me think this is not the case:

Yields have not been this low (except for one spike down in 2003 when the Fed was at the end of responding to the dot.com bubble bursting) in 55 years!  From an historical basis, the economy can certainly sustain growth at higher rates.

Which brings us to the scary chart.  Here’s the visual put together by the folks at the excellent blog site visualcapitalist.com – take a look and digest this, and I’ll give some thoughts below:

Click to view

The first thing that needs to be pointed out is that correlation is not causation.  We need to understand that an inverted yield curve does not cause recessions.  Rather, when long-term rates drop below short-term rates, it’s an indication that investors are anticipating an economic slowdown.  And that forward-looking fear has the market spooked.

It’s important to note that this is just a caution flag for us – it’s not yet a red flag.  If you look at the above chart you can see that the 10-year vs. 2-year treasury spread hovered between 0.5 and 0 for years before the 2000 recession.

So with all the wailing about interest rates, what can we practically do?  First, realize that trying to pick a market top is hazardous to your wealth.  It’s important to have a “get more of your account into cash” point for your longer-term or nest egg money. But it’s even more important not to miss long-term up moves in the market.

My analysis shows that we’re more likely to get another big move up before a bear move down (defined as a 20% pullback).

If you’re concerned about caution flags in the market and your nest egg money is overweight in the tech sector, I like the industrial stocks as a partial inflation hedge and a more defensive play.  The ETF symbol XLI is a way to play the whole sector.  Healthcare (symbol XLV) is also a sector that is both not interest rate sensitive and defensive (does better in market downturns than other sectors).

That should give you plenty of time and ammunition to prepare before the “Creeper” surfaces and – just as it does every 23 years – wants to eat.

Great trading and God bless you,

D. R. Barton

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