Forget conventional thinking: stock moves signal bond moves, not the other way around – MarketWatch

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Conventional Wall Street wisdom says higher interest rates eventually hurt stocks. But in the current environment, it will be a dramatic change in equities that hits rates, say some analysts.

Skittishness among stock investors of late, those who have been rotating out of high-flying technology shares, prompted pundits on Wall Street to declare that central bank hawkishness is behind such angst.

Read: What caused last week’s ‘taper tantrum’ in markets?

Bank of America Merrill Lynch economists in a note from Friday said that higher rates over the next six months will be negative for stocks and high-yield bonds. Very simply, when bonds lose favor their prices fall, sending their yields, essentially a term for market-set interest rates, higher. That raises borrowing costs for the companies that make up the stock market.

“Tightening by the Fed [and] rhetorical tightening by European Central Bank has already succeeded in raising bond yields, volatility, reducing tech stocks,” the note said. “Summer 2017 = massive inflection point in central bank liquidity trade … will likely lead to Humpty-Dumpty big fall in market in autumn, in our view.”

But when it comes to correlations and causality between bonds and stocks, the picture is much more complicated and constantly changing, according to Alex Gurevich, chief investment advisor at HonTe Advisors.

“In different market regimes correlations and causality play out differently across time scales. It is true that over the long term, stocks and bonds are negatively correlated, but over the short term, they often move in the same direction,” Gurevich said.

“In the current environment the stock market leads the way. If the stock market falls by 20%, then the Fed will view it as tightening of financial conditions and stop further hiking,” he said. “We may very well be in a recession by then. Under such a scenario, bond yields will fall as a reaction to stocks.”

Gurevich dismissed the notion that anyone can know where long-dated bond yields will be over the next six months, even assuming the monetary policy moves are known with relative precision ahead of time.

Read: Chart shows how terrible Wall Street economists are at forecasting Treasury yields

“Long-dated bond yields have declined every time the Fed raised rates in this tightening cycle, so it is wrong to assume they will simply rise with the next rate hike,” Gurevich said.

Indeed, the yield on the 10-year Treasury bond TMUBMUSD10Y, +0.68%  was at 2.2% in December 2015, when the Fed raised interest rates for the first time in a decade. The yield is currently at 2.4% after the fourth rate hike of the cycle so far, on June 14.

Short-dated bond yields, which are more sensitive to the changes in the Fed funds rate, are up much more in the same period, with the 2-year yield TMUBMUSD02Y, +0.62%  at 1.4%, the highest since 2008.

In fact, since the Fed began the tightening cycle, the spread between the 2-year and 10-year yield tightened, resulting in a flatter yield curve, which normally signals lower future economic growth.

If long-dated bond yields indeed reflect inflation expectations, then the picture there is of tepid growth.

“I don’t see any reason for why the long-dated bond yields would rise far above their current levels. Inflation is trending lower as commodity prices have been falling despite weakness in the dollar. Global demand is weaker everywhere,” Gurevich said.

In May, the personal consumption expenditure reading, the Fed’s preferred measure of inflation, hit an annual rate of 1.4%, down from 2.1% in February and back below the Fed’s 2% target.

Any upward change in inflation is likely to be reflected in the stock market well before the official, albeit backward-looking, data confirm it.

If Gurevich is right, investors are likely better off getting used to the idea that the stock market is the leading indicator, not bonds. Stocks will be the first to signal a change in yields, or ultimately, a recession.

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