When my dad was teaching me to fish for trout in the streams around our home town, there was actually a lot to learn.
One of the most important lessons was finding spots where the fish are. It seems simple, but in a good-sized stream there are lots of places to cast your fly or bait. Identifying the best ones makes the difference between a productive morning fishing and just throwing a hook in the water over and over again (sound a bit like trading?)
Lots of people look for places where fish can take cover – water under a low hanging tree branch or deep holes where fish can lie near the bottom unseen by predators above the surface. If you can identify those spots and pull a convincing hand-made fly or tasty bait past a fish’s nose, you have a chance for a strike.
But I quickly learned that the location to get the most bites is where fish are actively feeding. Finding swirls underneath rapids are good for this. But my favorite was finding a slightly deeper, fast-flowing channel in the middle of a set of rapids.
It didn’t look like much from above the water. But if you put on a snorkeling mask and look a little below the surface, you’ll see activity that makes it a veritable buffet line for waiting trout.
Bugs, grubs and larvae and even careless minnows and crawdads get caught up swept downstream in the fast-flowing channel. When this little channel empties into the slower moving water, turbulent mixing happens that’s not readily apparent from the creek bank.
And all those tasty morsels (tasty to a trout, anyway) get tumbled about, making them easy pickins’ for the agile fish lying in wait.
And yes, I did put on a mask and check out what was happening in those crystal-clear creeks when I was growing up. And while I wasn’t half the fisherman that my dad or younger brother were, I still got my fair share of wily trout by knowing what was happening under the surface.
Knowing what’s happening under the surface is key to understanding all the turmoil happing in the bond market as well. Let’s see why…
One Simple and One More Detailed Reason Bonds Are Affecting Stocks
When I teach third graders about economics, understanding the driving forces in simple terms is key.
One of those deep but simple truths is that money goes where it is treated best. We see that in currency world, where over the long term, currencies with the higher yields rise in value vs. those with lower yields because of an inflow of capital seeking the best returns.
The same is true when we look at the comparison of stocks and bonds. When U.S. bonds and notes pay higher yields to investors they become more attractive as an asset class relative to stocks.
So with the recent surge in bond yields, stocks have gotten weaker.
But the interesting thing is that this is just what we see at the surface. If we look at what’s happening under the surface, things really get interesting.
There’s a bigger game afoot when we look at how longer-term bonds relate to shorter term bonds.
Here’s the short version: the yield on a 10-year U.S. bond should be higher than the yield on a 2-year bond. That’s because you have more time exposure or uncertainty for a longer holding or maturity period. Issuers (in the case, Uncle Sam) have to pay higher interest rates for people and institutions to loan them money for a longer period time.
This relationship with long-term bonds having higher interest rates than short-term bonds is called a “normal yield curve” and looks something like this:
But a cautious trend has developed 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:
And it’s this “under the surface” problem with yields that has the market spooked. We’ll dig more deeply into past data, recession indicators and what we can do as a result in our next article.
As longer-term government yields flatten out, investors seek other places to put their long-term income money. As you know, finding potential income sources is a big part of what we do at “10-Minute Millionaire Insider.” You can learn more about how it works – and how to get one of our latest income investment opportunities, “Federal Rent Checks” – right here.
Great trading and God bless you,
D.R. Barton, Jr.