Bonds and the Stock Market:

How Do They Talk to Each Other?

It’s no secret that the stock market is unhappy about something – and that there are many things to be unhappy about. However, one item is dominant in our minds, though much less intuitive than trade problems, earnings issues, and the latest tweets. We’ve mentioned interest rates and their impact on stock market valuations many times in the past, but here we will give you a round up of what the bond market is trying to say and how that relates to stocks.

First off, an interest rate is just the price of money. If your bank charges you 5% for a mortgage, that is the price at which they are willing to lend. So with that in mind, what does the price of money have to do with stocks?

Trade issues and tweets have been on the table for months with nary a hiccup in stocks. However, the one incident that can be directly  and immediately tied to the stock market decline is the jump in long term interest rates that began on August 24th. While the long bond shifted up in yield for a week or two in somewhat desultory fashion starting then, it really got going on September 12th, when it broke to the upside and raced to 3.45% from under 3%. This move is both fast and far.

The long bond yield figures large in the valuation of stocks. The higher bond rates are, the lower stocks are valued. On the other hand, higher rates was a positive judgment on the economy, the same as the Fed is broadcasting, which is: things are strong. Competition for money is considerable, and so the market can charge more for those funds.

In some ways, this was comforting. We had the Fed saying, essentially, ‘the economy is still growing and we just want to feather the brakes a bit to avoid a crash so we’ll give you a few rate hikes’, and we had the long bond saying, ‘strength is in the cards, money should be more expensive because demand is strong’. Stocks should like that, but what investors didn’t like was the rapid change. From under 4%, mortgage rates jumped to 5%, and financing for all sorts of transactions shot up, all in about a month.

And then, a funny thing happened on the way to more rate hikes. A few soft economic statistics emerged, showing that housing had cooled considerably, some layoffs were announced, several earnings conference calls contained warnings about next year’s results. These warnings were not relegated to companies that must buy tariff-ridden steel, either. Bank managements, for instance, mentioned housing and the fact that middle market customers have slacked off borrowing again.

In reaction, the trend in the long bond reversed, and its yield began to fall. Rates in the middle of the interest rate curve, from two year to five years, inverted, so that the shorter maturities yield more than the longer maturities.

All of a sudden, the narrative switched from ‘too strong’ to ‘hey wait a second, maybe things are weak! Weaker than we thought!’ And that, right there, was enough to give stocks another leg down.

It’s hard to blame investors for reacting first to the surge in interest rates, and then to their sudden sinking and the inversion of a big hunk of the yield curve. This kind of action in bonds is like a normally soft spoken person suddenly starting to swear and shout. It’s alarming, and now you feel like you no longer know what that person will do next. Consequently, we think it will take some time for volatility in stocks to ease. It will also take a few weeks to determine if the downward direction is a new trend, or just an interruption in the old upward trend. We suspect the answer is the latter, and that we will look back on this time frame as marking the change to a slower growth trajectory, but no disaster.