Yield To Oncoming Traffic

Yield to oncoming traffic. Stocks traded off yesterday as jittery investors awaited this morning’s inflation figures. Bonds were higher yesterday and 10-year treasury yields slipped below a recent range floor.

N O T E W O R T H Y

Bonding.  In yesterday’s session stocks were down and bonds were up.  Wait, what?  That is how things are supposed to work.  At least that it how things used to work.  When investors are expecting strong economic conditions, stocks rally.  For bond investors, strong economic conditions mean inflation and higher rates which cause bonds to sell off.  Remember that inflation is a bond investor’s enemy, as it eats into their fixed coupon payments’ purchasing power.  The historical inverse relationship between stocks and bonds began to be tested in late 2018.  Stocks were in rally mode in the prior year as lawmakers passed the Tax Cuts and Jobs Act in the final days of the year. The deep cuts in corporate taxes would open the flood gates for stock buybacks and EPS growth, both catalysts for a stock rally.  A stock rally was overshadowed by the US trade war with China along with mounting tensions with its EU trading partners.  Investors were also concerned that the economic expansion that followed The Great Recession, already the longest in recent history, had grown long in the tooth.  Stocks had a tough 1st quarter but managed a rally in the 2nd and 3rd quarters.  Bonds traded down and yields climbed through that period.  The final quarter of the year was bad for stocks which saw a -6.5% decline in October and a small +1.8% gain in November.  In October, as stocks fell, bonds continued to fall as well.  However by December bond traders began to anticipate trouble, which led to a rally. Stocks encountered relentless selling, until the Fed stepped in, promising help, in the last week of the year.  The result: bonds rallied and stocks rallied, breaking the inverse relationship.  Stocks would see +29% gains for the year, spurred on by low unemployment and Fed rate cuts, referred to as mid-cycle adjustments by the Central Bank. Ten-year treasury yields began 2019 around 2.6% before dropping to around 1.6% in later summer and closing out the year at around 1.91%.  In other words, both bonds and stocks rallied! That put investors in a very untenable position.  Bond yields were near all-time lows and stocks were at all-time highs.  Any reversal could see both stocks and bonds fall, offering diversified investors no protection.  Then came 2020 and the pandemic. Stocks were hit hard in the first quarter but bonds rallied. Aggressive rate cuts and massive bond buying assured that yields would be kept low and 10-year yields plumbed new depths, touching a new all-time low of around 0.50%… just as stocks managed to rally back into positive territory for the year.  In other words, stocks and bonds were both going up, abnormally, once again.  I should note that during the entire timeline of our discussion, inflation was stubbornly low, rarely even mentioned in economic discussions.  But that would change in the final quarter of the year.  Vaccines were on the verge of being approved.  Lawmakers were preparing a second monetary stimulus package, the Fed continued to buy bonds, and there was an economic light at the end of the tunnel.  Economists began to forecast strong growth for 2020 as the economy reflated. That was good news for stocks and the rally continued.  Bonds, during that period, sold off as bond investors began to anticipate inflation.  The traditional, inverse relationship was back.  But wait, there was something new.  Higher yields and inflation began to spook growth stock investors.  The very same growth stocks that powered the markets in the post Global Financial Crisis era and through the pandemic recession, were now under pressure as higher yields make the present value of future earnings worth less.  Uh oh, stocks going down and bonds going down.  This time things looked a bit more dire.  Investors now expect inflation to spike as the economy reopens.  Bond yields, though higher than they were last year, are being artificially held down by the Fed.  If the Fed reverses course, yields would surely go up to account for inflation… and growth stock prices will be under increased pressure. Stocks, in general, are expensive by historical standards.  Bonds too, are expensive, considering the expectations for high inflation. This puts the Fed in a very tight spot.  The Fed has insisted that inflation is transitory requiring no course changes.  If inflation turns out to be more systemic and the Fed is forced to raise rates, both bonds and stocks will be under pressure.  If inflation turns out to be transitory and the Fed can maintain its current level of accommodation while methodically normalizing policy, things can return back to normal. Stocks can resume their growth and bond yields can slowly return to normal, offering positive real yields.  The Fed is hoping for that scenario, and so are we.  Ten-year treasury yields slipped below 1.5% yesterday and an auction of new notes from the Treasury had strong demand.  This can be an indicator that bond investors are beginning to believe the Fed’s thesis, lowering long-term inflation expectations.  Stock investors were more cautious, they sold shares yesterday in anticipation of this morning’s inflation figures, which are expected to show another jump in consumer prices.

THE MARKETS

Stocks sold off yesterday as investors were cautious ahead of this morning’s inflation numbers. The S&P500 fell by -0.18%, the Dow Jones Industrial Average sold off by -0.44%, the Nasdaq Composite Index slipped by -0.09%, and the Russell 2000 Index dropped by -0.71%.  Bonds rallied and 10-year treasury yields slipped by -4 basis points to 1.49%.

NXT UP

– Consumer Price Index (May) is expected to come in at +4.7% compared to last month’s +4.2% read.  Excluding food and energy, the figure is expected to be +3.5% up from the prior month’s +3.0%.

– Initial Jobless Claims (June 5) is expected to be 370k, slightly lower than last week’s 385k claims.

– The treasury will auction off $24 billion 30-year notes.  It will be an interesting test of inflation expectation considering yesterday’s strong 10-year auction demand.

– Chewy and Dave &  Busters will announce earnings after the bell.