Attention, Stock Investors – The Bond Market Has a Message for You

Watch bonds to see if cyclicals or defensives will outperform in the second half

Equity investors in general, and traders in particular, should be paying close attention to the bond market right now. That’s always the case, but the need is particularly acute at the present time since the five- and 10-year notes both have important — and different — stories to tell.

What the 10-Year Is Saying About Growth

A look at the year-to-date performance of the 10-year T-note seems to provide a clear message: the economy remains in slow-growth mode, and that isn’t going to change any time soon.

The 10-year yield, which opened the year at 3.03%, is now approaching 2.4%, the level that served as the low in late April. (Keep in mind, prices and yields move in opposite directions).

This 2.4% level is critical. If the 10-year breaks this prior low, it has a straight shot down to the 2%-2.2% range as it fills the gap established in June 2013. So far, the stock market has been able to write off falling bond yields to various technical issues — such as supply and demand factors, declining yields in Europe, short covering, etc. — rather than a more meaningful slowdown in growth.

If the 10-year approaches 2%, however, the message from the bond market — that the economy isn’t as strong as the bulls believe — can no longer be ignored.

10-Year Treasury Yield

10-year Treasury yield, 18-month chart

In the event that such a breakdown in fact occurs, investors in cyclical stocks will need to take the appropriate precautions. Conversely, rate-sensitive issues, defensive stocks and low-volatility ETFs — not to mention any security offering a decent yield — would be poised for continued outperformance.

To be clear, it remains to be seen whether the 10-year yield will indeed break below 2.4%. With such a strong rally already in the books so far in 2014, it won’t take much in the way of better-than-expected economic data to send yields higher again.

Still, the Treasury market is seen as being the “smart money” when it comes to the growth outlook. If you own stocks, you need to keep a close eye on the 10-year Treasury in the second half.

If the economy is about to fall off a cliff, the Treasury market will be the first to know.

The 5-Year Paints an Entirely Different Picture

The drop in the 10-year yield isn’t all there is to the story, since the five-year note is sending a message of its own.

Even as long-term yields have plummeted, the five-year yield has continued to trade sideways and — at Friday’s close of 1.68% — is actually fairly close to its previous high-water mark of 1.84%.

5-Year Treasury Yield

Five-year Treasury yield, 18-month chart

The key to performance here is the outlook for Fed policy: Even as the long end has performed well this year, shorter-term issues (five years and in) have produced much weaker returns — a reflection of the fact that each day that passes brings us closer to the point at which the Fed will enact its first rate hike.

If the five-year moves above this 1.84% level, it will be a clear indication that investors are bailing on the shorter end of the curve. In turn, this would represent a sign that concerns about future Fed rate hikes are becoming more immediate.

While the start of rate hikes in 2015 couldn’t be more clearly telegraphed — indicating that the impact on the stock market should be fairly muted — there are three reasons why a breakout in the yield chart of the five-year would be an important development nonetheless.

  1. First, it will tell us that the surprising bond rally of 2014 has come to an end, and that longer-term bonds are likely to begin feeling the same pressure that short-term debt has through the first six-plus months of the year.
  2. Second, it’s a sign that other segments of the bond market that outperformed so far this year — specifically corporates and high yield — are about to hit the wall.
  3. Finally — and most important for stock investors — it’s a clear signal that rate-sensitive sectors will begin facing headwinds, while the more cyclical areas of the market could be poised for outperformance.

Putting It All Together

Keep an eye on these two charts in the weeks and months ahead. They will provide a clear indication as to which issue — slower growth or Fed policy — is the more pressing concern for the financial markets as we move deeper into the second half.

What’s more, the fact that they tell such different stories — and that the five-year is nearing a breakout even as the 10-year sinks toward support — means that the ultimate resolution of this disconnect has very meaningful implications for all segments of the financial markets.

The bottom line: Even if you aren’t invested in bonds, it’s time to start paying attention to the Treasury market.

Article printed from InvestorPlace Media,

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