Why Bonds Are Piquing Our Interest

JC Parets
August 12, 2020

From the desk of Tom Bruni @BruniCharting

I wrote this post for our Indian subscribers, but given it's discussing Interest Rates and their effect on Equities as an asset class I thought it was worthwhile to share it with you all as well.

We've written about the rotation that's underway here, here, and a lot of other places, but this post helps tie it all together with the recent action in Bonds.

I hope you find it helpful.

Last week for US subscribers we discussed the potential breakout in US Treasury Bonds, but that move quickly failed. If we've learned anything over the years, it's that failed moves often lead to fast moves in the opposite direction...so this decline could just be getting started.

In this post, we want to analyze the near-term direction of Interest Rates and discuss why they're relevant to Equities as an asset class.

First, let's start with the US 30-Year Note. Since we're interested in the direction of Interest Rates across the entire curve, we want to be looking at the longest duration vehicle we have access to. The longer the maturity of the Bond, the more sensitive its price is to Interest Rate fluctuations.

As we can see, prices tried to break above resistance near 182.50-183.00...even making a new daily closing high, but quickly failed. Today we saw significant downside follow-through, suggesting this could be the start of a move back towards the lower end of the March-August range.

Click on chart to enlarge view. 

And if we look at Developed Market 10-Year Yields, we see something similar. Many of them pushed to new marginal lows (or highs for their Bonds) and are attempting to turn higher. Point being, this could be the start of a meaningful move higher in Interest Rates globally.

In India we're seeing something similar, though not to the same extent. Nothing to get too excited about yet, but they are trying to stabilize and turn higher with the rest of the world.

So why does this matter? From a stock market perspective, we want to be looking at Interest-Rate sensitive sectors to identify how Equity-market investors are expecting Interest Rates to behave going forward.

Looking at the ratio of Regional Banks to Real Estate Investment Trusts, we see prices stabilizing above support and moving higher. This signals that the market is beginning to price in higher Interest Rates because they're rotating out of a sector that benefits from lower Interest Rates (REITS) and into a sector that benefits from higher Interest Rates (Regional Banks). The same can be said for US Financial stocks relative to the rest of the US stock market. That ratio is holding support and attempting to move higher too.

The point here is that we're finally starting to see a rotation into more cyclical areas of the US stock market, which could fuel its next leg higher. Take a look at Financials, Industrials, and Energy, which have been serious laggards since stocks bottomed in March. They consolidated sideways and are just now starting to work their way higher over the last week or so.

The question we're asking is whether this rotation is the start of a sustainable move higher in these stocks, or is it simply more mean reversion before Technology stocks and other leaders reassert themselves?

So far the weight of the evidence across the Equity, Fixed Income, and Commodity markets is suggesting this could be real rotation. And if we're seeing money flow into cyclical stocks in the US, we'll likely see that trend play out in other markets around the globe too.

Here's a chart of US Financials compared to the Bank Nifty Index. Will Indian Banks follow suit and push to new recovery highs?

That would certainly be a positive, especially as the Bank Nifty/Nifty 100 ratio we tracked as part of our "Five Bull Market Barometers" tests a key level of support near 1.91. The largest sector of the market beginning to outperform again would be a welcomed development.

To conclude, it appears that Interest Rates could be at a potential inflection point in the US and globally. If this truly is a turning point for Interest Rates, the rotation we're seeing back into cyclical stocks is likely just getting started. From an intermediate/long-term perspective, this would be a positive for the bull market in Equities as we'd see a broadening out of participation amongst the stocks that comprise it. A "stock market" is simply a market of stocks, after all...

As we noted, these are very short-term developments that could be the start of something bigger...or they could just be another bounce within the context of their long-term trends.

Either way, it's worth keeping an eye on this theme in the coming weeks to see how it develops.

Thanks for reading and please let us know if you have any questions.

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