The trader Alex Barrow recently observed that the sentiment backdrop is setting up for a bond market rally.
While Barron’s is not as reliable as The Economist as a contrarian magazine cover indicator, the stars appear to be lining up for a counter-trend rally in bond prices. Here is what a potential bond market means for the other major asset classes.
Bond market rally ahead?
Notwithstanding Barrow’s sentiment model observation, a number of other indicators are pointing to downward pressure on bond yields and upward pressure on bond prices. The Citi Economic Surprise Index, which measures whether economic indicators are beating or missing expectations, has been falling. Growing growth disappointments should act to depress bond yields.
You can tell a lot about market psychology by the way it reacts to the news. Fed vice-chair Richard Clarida raised the possibility of a QE taper in a Yahoo Finance
“It may well be” that “in upcoming meetings, we’ll be at the point where we can begin discuss scaling back the pace of asset purchases,” Clarida said Tuesday in a Yahoo! Finance interview. “I think it’s going to depend on the flow of data that we get.”
In response, the 10-year Treasury yield fell on the news. From a technical analysis perspective, the behavior of the 10-year yield is constructive for bond bulls as it violated a rising trend line and it is in the process of testing an important support level.
History shows that bond yields have fallen whenever the Fed tapered. This a counterintuitive result but tapering has not been bearish for bond prices.
The bond market’s reaction can be explained by an acceptance of the Fed’s full employment narrative. The low-income employment recovery is still lagging, which is an indication that the Fed will remain dovish for some time.
Transitory inflation fears
The bond market was briefly jolted Friday when Core PCE, which is the Fed’s favorite inflation indicator, spiked to an above expectations level of 3.1%. However, George Pearkes
of Bespoke Investment Group pointed out that only five categories accounting for 3.2% weight in expenditures generated nearly two-thirds of the PCE surge.
The Fed is likely to shift its focus from Core PCE to Trimmed Mean PCE
, which remains tame.
In short, price increases are not widespread and can be explained by supply chain bottlenecks. This is what “transitory” inflation looks like.
Growth stock counter-trend rally ahead
While it’s difficult to make a call on the direction of the S&P 500 based on a possible bond market rally, market internals are likely to shift, especially in light of this highly bifurcated stock market environment.
Growth stocks have long been thought to be high duration instruments. That is to say, they tend to be more sensitive to changes in interest rates. Investors should therefore expect that falling bond yields to benefit growth stocks over value stocks.
Financial stocks, which comprise a significant portion of the value stock universe, don’t perform well if bond yields are falling. Falling bond yields should flatten the yield curve, as the short-end is already pinned at zero or nearly zero. In the past 10 years, the relative performance of bank stocks has been correlated with the shape of the yield curve. A steepening yield curve has historically boosted bank shares because they have a tendency to borrow short and lend long. This tight relationship diverged in 2017 because of the Trump tax cuts, which raised banking industry profitability.
Indeed, the performance of the Rising Rates ETF (EQRR), which is overweighted in the value and cyclical sectors of Financials, Energy, Materials, and Industrials, has begun to underperform the S&P 500. Investors should therefore expect a pause in the reflation and cyclical trade should a bond market rally begin to materialize in earnest.
The market breadth of value against growth is also signaling a turn towards growth stocks. The spread of percentage bullish on point and figure charts and percentage above their 50 dma are all moving against value towards growth.
So far, the long-term trend of a value turnaround remains intact. The analysis of value and growth ratios by market cap band shows that mid and small-cap value stocks are the most vulnerable to a value/growth reversal owing to the steepness of the recent performance of value stocks in those market cap band groupings.
The possibility of a counter-trend relative rally by growth stocks does not negate my long-term bullish outlook for value stocks. Nothing goes up or down in a straight line. The history of the value revival in the wake of the dot-com bubble shows that there were brief interruptions in the value rally. I expect that any growth reversal is just a brief interruption. While traders could position themselves for outperformance by NASDAQ and speculative names, investors could regard such an episode as an opportunity to lighten up on their growth positions and rotate into value.
USD and gold
A falling bond yield also has important implications for the USD and gold prices. The yield spread between Treasuries and other major currency debt instruments has been narrowing, especially against Bunds. Further downward pressure on the UST yields will put downward pressure on the USD Index, which is already testing a key support zone (bottom panel). This is greenback bearish. Since gold prices tend to be inversely correlated with the USD, it is by implication gold bullish.
From a technical analysis perspective, both gold and gold mining stocks have staged upside breakouts from multi-month flag formations, which are bullish continuation patterns. In addition, gold prices are also highly dependent on real rates. TIPS prices (red dotted line, top panel) have been rising steadily and they are forming a bullish divergence. As well, TIP vs. IEF (7-10 year Treasury ETF, grey line, bottom panel) have been rising in lockstep with inflation expectations. I interpret all of these conditions as bullish for gold prices.
In conclusion, the market is setting up for a bond market rally of unknown magnitude and duration with the following implications for other asset classes:
- Bullish for growth stocks over value stocks;
- Expect a pause in the cyclical and reflation trade, which is highly correlated to value;
- USD bearish; and
- Gold bullish.
Tactically, I would watch for a definitive upside breakout in bond prices as the bullish trigger.
Disclosure: Long GDX