From the desk of Steve Strazza @sstrazza and Grant Hawkridge @granthawkridge
They say the Bond Market is where the smart money is. Maybe it is. I have no idea.
What I do know is that it’s where a lot of the smart information is.
Due to the diversity among credit instruments, there is a swath of unique data that we can use not just for Bond prices and Interest Rates but also to glean insight into other asset classes.
I’m talking about things like TIPS for inflation expectations and Emerging Market or High Yield Bonds to analyze risk-appetite for other assets such as the stock market.
Alpha has been in Equities and risk-assets for a while now. As such, we haven’t needed to discuss bonds from a portfolio perspective… but that doesn’t mean we aren’t paying close attention to these assets.
The Bond Market is overflowing with information. We’d be foolish to neglect it.
In this post, we’ll dive into what we mean by this and share some of it with you. We’ll also discuss the implications of what we’re seeing in the Bond Market on its alternatives, and more importantly, what these alternative asset classes are suggesting about Bonds and Yields right now.
What yields do from here is as important as anything for our bullish thesis to remain intact right now.
Looking at our Intermarket ratios and different Bond instruments on an absolute and relative basis gives us information about the level of risk Bond Market investors are seeking. More importantly, though, it offers insight into the direction of yields.
Let’s dive right in and see what the weight of the evidence is currently suggesting for Interest Rates.
We outlined our position around the summer of last year and have remained in the same camp ever since… It’s basically this:
Inflation is on the rise. Interest rates are trending higher. Expect lower Bond prices and continue to favor stocks.
Now let’s take a step back and consider what’s happening in Bond Markets around the globe.
Interest rates worldwide bounced along with the US in Q1 of last year and most Developed Market Yields have continued to grind gradually higher in the time since.
As you can see, the US isn’t the only country whose benchmark 10-year yield is near new 52-week highs.
Although, it’s definitely been one of the strongest as it just broke out of its recent base to its highest level since last March.
Due to the velocity of last year’s decline, there is very little price data between the current level and those key multi-year lows around 1.40%. These pockets of price memory act very much like gaps and are often filled aggressively.
When you consider this in addition to the fact that it should have some fuel at its back from almost a year of basing, we wouldn’t be at all surprised to see a swift move higher.
Here’s a long-term view.
This steady ascent in yields around the globe has put pressure on International Credit Markets as investors have embraced risk assets over their more defensive alternatives.
Money always flows to where it is treated best and right now that is just NOT Bonds.
After an almost vertical move off the March lows, the ratio is retesting its all-time highs from late 2018. A lot of the heavy lifting has already been done as it broke above its multi-year downtrend line last summer and reclaimed more recent resistance at the 2019 and 2020 highs around 2.40.
As long as we’re above that level, stocks are the place to be over both the short and long timeframes.
For a different perspective, rather than the S&P 500, let’s look at how bonds are performing relative to the strongest equity index in the world, the Nasdaq 100 $QQQ.
This ratio is even stronger and has been breaking out to new record highs relative to bonds since last summer. The primary trend will remain intact and in favor of stocks as long as this ratio is above its Q4 2020 highs.
I think it’s safe to say that investors’ money has been treated a whole hell of a lot better by the stock market for almost a year now.
We see no sign of this changing. Let’s discuss why.
Here is a look at the US 5-Year yield. As many of you know, this has acted as an incredible indicator for Bond Market investors in the past as it tends to lead at key inflection points.
But that’s not what we’re seeing this time. Unlike the 10-year, the 5-year yield is still working on resolving higher from its base.
It’s facing some significant resistance just overhead at its former all-time lows, but when we zoom in it sure looks like it wants to follow the 10-year’s path higher.
You’ll notice it’s pulled back a bit since slicing slightly above its April and June pivot highs a few weeks ago. Although with momentum finally back in a bullish regime, we think the current pullback is nothing more than a continuation pattern.
In fact, it looks a lot like a little false start and bull-hook to me. Looking at the two together now and the patterns are almost identical… do you really want to make the bet the 5-year doesn’t resolve higher as well?
We don’t. It looks like the 10 might actually be leading the 5-year this time around. On the other hand, you could interpret this lack of confirmation as the 5-year telling us to be wary of the recent breakout from the 10-year.
We should know soon. If the 5-year is above the 2012 lows and recent highs around 0.54%, the bias is higher, and we believe a structural reversal in US interest rates is underway.
This would be a major development for yields around the globe.
It would also reinforce our thesis that investors continue to reach for more and more risk. Along those same lines, it would confirm the recent bid for cyclical and reflationary assets and support a continuation of this trend.
Here is the 20+ Year Treasury ETF breaking down beneath key support at last year’s lows.
TLT printed a bearish breakaway gap in January at its recent lows around 155. The new lows were confirmed by an oversold RSI reading (not shown).
Treasuries tried to reclaim that former support level this week and immediately failed.
The market has spoken. Investors are favoring risk assets and tossing defensive ones to the curb.
As long as TLT is below 155 the risk is to the downside and we’re short with a 1-3 month target at 138.
In this kind of environment, it makes sense to see Bonds break down while Stocks and Commodities keep grinding higher.
Here’s the ratio of Long-Term Treasury Bonds relative to their Short-Term peers.
The prior uptrend is clearly under pressure as price just violated key support at its prior lows around 1.80. But what does this tell us?
The long-end of the yield curve tends to outperform during periods when Bond prices are rising. The opposite is true when they are falling and rates are rising.
In a rising rate environment, it is normal to see yield spreads widen like they are now, as evidenced by this ratio declining.
Therefore, a long-term reversal in favor of Short-Term Treasury Bonds would suggest that longer duration yields will outpace the short-end of the curve which is a development we tend to see when bonds are trending lower on an absolute basis and rates are heading higher.
Now let’s look at some of our favorite intermarket ratios we use for an early read on rates.
Let’s start with Treasury Inflation-Protected Securities $TIP relative to Treasuries.
When this ratio is rising it tells us that Bond Market participants are anticipating inflationary pressure in the future.
Like most markets, we’ll usually see these reflationary expectations show up in price long before they show up in the actual economy. It almost feels like cheating, doesn’t it?
In the case of inflation-protected Treasury Bonds relative to traditional Treasury Bonds, the ratio has moved in a straight line higher off last year’s lows. After blasting through its pre-COVID peak and then some, it’s now at new multi-year highs.
This reflationary positioning would be expected in an environment of rising rates, higher commodities, cyclical leadership, emerging market outperformance, and a weaker dollar. It is all a part of the risk asset theme we’ve discussed ad nauseam.
Speaking of themes we discuss nonstop, another recent development that supports rising rates is the outperformance from Small, Mid, and Micro-Caps relative to their Large-Cap peers.
What’s the Commodity complex telling us about yields?
Well, Industrial Metals have been outperforming Precious Metals across the board. Why do we care?
It could have something to do with global growth and increasing economic activity which ups the demand for base metals… it would make sense with a backdrop of rising rates and inflation. But that’s not why.
We watch the ratio of these metals for information because it has a very high positive correlation with yields. If you zoom out at the two charts, they look almost identical.
Here’s the Copper vs Gold ratio with the 10-year overlaid. It bottomed and turned higher last year and is currently trading just off fresh 52-week highs.
Seeing this ratio back above its pre-COVID highs suggests that interest rates could easily do the same.
How about the currency market now?
Let’s check in on the best commodity-gauge and risk-barometer of all fx crosses… the Aussie/Yen.
There is just so much good information here. The Aussie Dollar is heavily tied to economically-sensitive assets and industrial commodities in particular. When they are in bull markets, the Aussie is likely trending higher against other currencies as well.
This is especially true for the safe-haven Japanese Yen. When times are good and investors are pricing in growth and inflation, there is a higher demand for Aussie. When the opposite is true and investors are on defense, they’re buying Yen.
As you can see, it’s been all offense ever since the COVID lows. The AUD/JPY trading at its highest level in more than two years is the market’s way of saying, “let the good times roll.”
Tied into the higher interest rate picture is the performance of Financial stocks. It’s challenging to have a global bull market without Financials, at the very least, not going down. They do not necessarily need to outperform, but we never want to see them falling on an absolute basis while the rest of the market heads higher.
After a 13-year base, Financials are back up near their highs from 2007. While tests have become far more frequent since 2018, sellers continue to step in and reject prices around this key 31 area.
While we wouldn’t usually look to Financials on an absolute basis as an indicator for interest rates like this, in this scenario it makes sense. This is a critical index and price is at a critical inflection point… and Financials obviously have the highest correlation with yields than any other group of stocks.
So, let’s keep it simple. If Financials finally break out of this monster base, it’s probably happening in the context of rising interest rates.
Digging into Financials and Regional Banks are definitely the Industry Group most impacted by changes in interest rates. This is because far more than the Large-Cap Money Center Banks, an overwhelming share of their revenue is generated from lending.
Long story short, higher interest rates and wider yield spreads are a tailwind for these stocks, more so than any other. Just look at the outperformance from Regional Banks over their Large-Cap counterparts since rates began trending higher.
Regional Banks relative to REITs is another of our favorite cross-asset ratios we watch for insight on yields. Unlike the big banks, the denominator in this ratio typically moves in the opposite direction of yields. REITs are often referred to as “Bond-Proxies” as they mimic the action of these defensive assets.
Seeing price make a sustained move above those 2017 highs and currently holding above this level is another feather in the hat for higher yields and the reflation trade in general. That’s a nice base.
Another Bond-Proxy sector we watch for insight on a relative basis is Utilities $XLU.
And you can skin the cat a million different ways so you need to be careful to keep your intermarket analysis consistent and not overcomplicate things. Let’s switch the denominator back to the overall market now and look at these safety sectors relative to the S&P.
Utilities and Real Estate both recently made fresh all-time lows relative to the S&P 500. This is consistent with an environment of lower bond prices and higher interest rates. In fact, if you were to flip these charts upside down and overlay the 10-year, you’d see another very strong correlation.
However, what if these two patterns end up being failed breakdowns and both ratios soon reclaim their former lows and rip higher?
First of all, it hasn’t even happened yet and the weight of the evidence is strongly suggesting it never will. But even in the case it did, it would only be one or two data-points amid a sea of indicators suggesting the opposite.
For now, the picture regarding interest rates is clear… the weight of the evidence strongly supports higher yields and lower bond prices in the future. From an intermarket standpoint, we’re seeing confirmation of this across ALL asset classes – from Regional Banks vs REITs within the Equity Market to the Aussie/Yen and Copper/Gold for Currencies and Commodities… They’re all pointing to higher rates.
And while all the confirming evidence adds to our conviction, we really don’t even need to complicate it that much – price alone is signaling higher rates and lower bonds. And as we discussed, while we may not want anything to do with this entire asset class on the long or short side, we always want to pay attention due to the wealth of information Credit Markets offer.
We’re anticipating US yields to accelerate their move to the upside in the coming weeks to months. This all fits into what we’re seeing from cyclical and economically-sensitive areas of the market as well as our broader thesis of a fresh bull market… and our desire to own stocks and other risk assets to best take advantage of it.
What do you think? Are rates finally headed higher?