10-Year Yield (Bemchmark) vs. the Market

This post is sort of a follow up on today's earlier post, Gold is Telling Us Something . As noted in the post, "Gold is typically bought on inflation EXPECTATIONS", meaning before the trend on inflationary pressure starts. The F_E_D has two mandates, maximum employment and keeping inflation at their long term target rate of 2%. However, what happens if recent inflationary trends continue? As mentioned earlier today, despite best intentions and guidance, the F_E_D has no choice but to hike interest rates sooner than the market expects and that's one thing in the median forecast of F_E_D members that was amiss upon yesterday's release, the year end target for inflation for 2015 and 2015 were both higher than the previous meeting and the previous meeting was higher than expected.

As The F_E_D's unofficial mouthpiece, the Wall Street Journal's Jon Hilsenrath wrote yesterday, "The F_E_D's new interest rate forecast imply slightly more aggressive credit tightening plans taking shape, more than previously thought". 

Why do you think gold was up today, GLD +3.5% in the biggest single day move in 9 months, SLV (silver) jumped +4.57% both precious metals are a natural hedge against inflation. This morning around 8:24 a.m. someone bought a half a billion dollar's worth of Gold futures in a 1 minute bar (they did alright for themselves today). One day after the F_O_M_C and with the %USD virtually flat, we see this very strong reaction in inflationary hedge assets, the market is obviously (and I believe has been as we have been following gold miners) anticipating higher inflation and higher inflation when not accompanied by a robust economy is not good. Real wages are falling on a year on year basis, not even holding but falling. It seems the market took this to mean the F_E_D will have to act before the market had anticipated, I suspect that's why we had no follow through today (the concept of a strong move being confirmed the next day with another strong move), that and the knee-jerk reaction associated with F_O_M_C and F_E_D events.


While a discussion about interest rates, bonds/treasuries and how they relate to the market can be very challenging as there are so many dynamics, in looking at some very simple trends I've captured a few charts for you that might also be telling us something.

First I'm using the Yield of the 10-year benchmark Treasury, this is used to set all kinds of interest rates from car loans to 30 year mortgages. The important thing to remember is Yields move opposite the treasury itself so if a treasury bond is selling off it will see higher yields. As the price of the bond falls, higher yields are needed to attract investors, by the same token, demand for treasuries produces lower yields, it's pretty basic supply and demand, the more demand, the less the yield, when demand weakens, yields increase.

The other broad concept to remember is Treasuries have traditionally been a "Flight to Safety", when there's fear or concern about stock prices falling, investors will move in to the safe haven of Treasuries which has the effect of lowering yields as there's more demand for treasuries. There are some caveats that apply because of F_E_D QE and ZIRP (Zero Interest Rate Policy) which the F_E_D Funds rate is near at 0.10%, it's basically the lowest the Central Bank can push interest rates using conventional policy (QE would be unconventional), under ZIRP the F_E_D is doing all it can possibly do to drive growth using conventional monetary policy.

So lets look at some charts and see if yields are maybe telling us something as well...

*In green are the 10 year yields, in red the S&P-500. A reading to the right of 30.00 would represent a 10-year yield of 3.0%, a price of 28.22 would be a yield of 2.822%.

We often use yields as part of our Leading Indicators as they tend to pull price toward them, you've seen the indicator many times in Leading Indicators Updates. The normal correlation between yields and the market is almost identical, it's when there are divergences that we have useful information about the direction of the market, but we generally use these on a short term basis, we'll be looking at longer term trends.

 As of 1998, notice how yields trace the SPX (red) and through most of the chart's history until we get to the 2007 market top and after that there's a large disconnect as the F_E_D engaged in non-conventiaonal policy, namely QE which was buying of MBS and treasuries, which skews the normal relationship, but as we taper out of QE the normal relationship seems to be returning.

Falling rates=rising bond prices, which is the "Flight to Safety" trade as investors take money out of stocks and put it in the safety of government Treasuries.

Rising rates=Falling bond prices, this is a risk off trade and the money typically moves from treasuries as they are sold, to stocks, the "Risk on" trade.

 This is the 2007 top period, note how rates of the 10-year treasury are climbing with the SPX (bond prices are falling as the "Risk on" trade is in effect, however at the very top of the 2007 bull market yields do not follow the SPX to a new high and instead decline, this is because investors are taking money and putting it to work in Treasuries in the flight to safety trade, not long after that divergence the market had not only topped, but dropped until the 2009 lows, erasing 5 years of bull market gains and then some in 18 months.

 Looking at the 2009 lows as QE was first started by buying MBS in late 2008, then treasuries were added in early 2009, yields diverged positively as money was leaving bonds and flowing back to stocks in the risk on trade, after that they generally move together.

In both cases, 10-year yields gave early warning of both an absolute top and an absolute bottom.

 Late July of 2011 we saw the start of a decline in the SPX in to early August as the market had been ranging for several months before (like recent market action since February through most of May),  again the 10-year yield diverged as there was a flight to the safety of bonds and out of stocks by large players in the market. This decline was nearly -20% in a very short period.

Remember, yields/rates move opposite treasury prices.

 Before 2007 the two move pretty much in unison, at 2007 we have a divergence between yields and the SPX leading to the market top (red hash mark) and another at the lows of 2009 (white hash mark). After 2009 with ZIRP and unconventional F_E_D policy (QE), yields and treasuries saw al kinds of non-conventional pressures so they weren't very helpful during that period, but remember we are now down to a $35 billion taper and keep unwinding. 

 One interesting event was at the 2013 April F_O_M_C when the F_E_D was very hawkish saying they expected QE to be completely unwound by the end of 2013, some members wanted to start right away, this spooked the bond market expecting interest rate hikes as the F_E_D's guidance up to that point had been the first interest rate hikes would take place 6 months after the end of QE, this sent yields soaring to over 3% which spooked the F_E_D, you may recall some of my articles as the next several F_O_M_C meetings said virtually nothing about tapering QE and talked reassuringly about interest rates being held low for an extended period long after QE ended. The bond vigilantes essentially scared the death out of the F_E_D, Bernanke made a inter-meeting address to halt the rise in rates (orange hash mark as rates peaked over 3% quickly), nothing kills a market like anticipated or real interest rate hikes from the F_E_D, the bond traders were essentially discounting that outcome and that's the reason rates rose so quickly, NOT WHAT THE F_E_D WANTED!

 AGAIN WE LOOK AT THE VERY TOP OF THE 2007 BULL MARKET and you see the divergence in rates heading lower meaning treasuries were bid in a flight to safety.

Note how similar our current market, SPX vs. rates looks now below...

Looking at the current market from just before 2014, note the same pattern among rates, experts had thought the QE taper would cause rates to rise and didn't understand the falling rates. In addition, low inflation generally means low rates, however as we recently saw in the CPI (and other data), there are real inflationary pressures. Remember the F_E_D's target for inflation is 2%, but they'd like to keep it as low as possible for as long as possible so they aren't forced to hike rates.

In May, economists didn't understand why treasuries were trading with the SPX rather than yields after better than expected business inflation, upbeat jobless claims (which is already below the F_E_D's stated goal and inflation is above, they have met and surpassed both mandates, only the economy is not doing so great. All of the perceived good economic news "should" have led to higher rates, it didn't. Some think that the market is not buying the "healthier economic recovery", however if you look at the charts above, rates now vs 2007 and rates' ability to call tops and bottoms with uncanny accuracy, considering the inflationary trend...

Look at the CPI trend since the 1.1 reading, inflation has nearly doubled, this is what Yellen called, "noise" in yesterday's press conference, but with a trend like the last 4 bars, with food inflation up .5% in May and .4% in each of the 3 prior consecutive months and energy up .9% in May as well as housing, new cars, airline tickets, medical care, prescription drugs and a lot more (in an environment of real falling hourly wages", I think it's reasonable to wonder if Gold is telling us something about the market's take on inflation and rates are telling us something about the F_E_D's inability to hold down rates as an inflationary trend would force their hand to hike. 

Remember, the market always front-runs the F_E_D.