The Bond Market's Latest Signal

“Equities follow credit” goes one Wall Street adage. It can certainly seem at times that the bond market knows something the stock market doesn’t.

The relative performance of stocks and bonds is usually an inverse one—stocks rise as bond prices fall, boosting their yields. When inventors are optimistic and willing to take on more risk, they shift their portfolios away from equities and into credit. And the reverse tends to be true as well—investors seeking safety sell stocks and buy bonds.

During several periods over the past year that relationship has broken down, and bonds have recently proven to be ahead of the curve. From the start of 2019 until the late summer, the S&P 500 marched to record high after record high, returning over 18% from Jan. 1 until Sept. 4. The yield on the 10-year U.S. Treasury note, meanwhile, fell to 1.46% from 2.63%, as the Federal Reserve lowered interest rates several times—breaking down the traditional pattern. 

From September until the end of the 2019, stocks continued to rise, the Fed cut once more then held rates steady, and bonds resumed their normal relationship with stocks. The S&P 500 returned another 11% and the 10-year yield rose to 1.91% as the price of the security fell.

The pattern reverted as 2020 kicked off. The stock rally continued, but bond prices began to crawl higher as well, and yields fell. The S&P 500 added another 5% through its latest record high on Feb. 19. Meanwhile, the 10-year yield declined to 1.52% as investors positioned to reduce risk. 

That proved to be a prescient move. It was nothing but down for the S&P 500 and the 10-year yield for several weeks after that, as the coronavirus’ impact on the U.S. economy became very real, very fast and threatened a financial crisis. Stocks crashed and bonds resumed their status as a hedge.

But the bond market again began sending a new signal by the second week of March. The 10-year yield bottomed out at 0.50% on March 9, and rose from there, to 1.27% by March 18. Stocks also bottomed the following week, and have rallied massively since, up 28% from their bear market low.

As they have climbed, bond yields have quietly given back most of their mid-March gains. The 10-year yield has tumbled back down to 0.61% at today's close. While small absolute changes, those are all big relative swings, especially for what’s traditionally regarded as one of the safest, most stable securities around. 

For the third time in 2020, investors may want to ask themselves what the bond market knows that the stock market currently doesn't. If the pattern holds, credit could be sending another signal that equities are due for a fall.