The stock market has been able to ignore the substantial rise in oil prices and in bond yields so far. However, stocks have been able to do that in past…only to see a significant decline eventually. With the rise in Treasury yields now taking them to multi-decade highs, this “eventual impact” on stocks could be sooner than most investors realize right now.
It’s not just the Treasury market that is creating problems. The high yield market is falling in the same kind of substantial manner that has been followed by very rough patches in the stock market as well…..…Like it is with the relationship between stocks and Treasuries/oil prices, a decline in high yield prices doesn’t matter…until it does. And when it does, it’s significant.
It was a bit of a rough day for the stock market yesterday…and the renewed rise in long-term interest rates pushed the US 10-year yield back above 5%. In fact, the move pushed that yield above 5.1%...it’s highest level of this cycle…and the highest level since the summer of 2007 (just before the Great Financial Crisis). Part of the big jump in yields was due to some more “Fed speak”…as Fed Governor Michael Barr said that more tightening is likely needed to return inflation to target…and some of the move also had to do with the poor reception of the 5-year auction early in the afternoon…….Finally, the almost 4% rebound in crude oil…which took Brent back up above $100…had an impact as well.
The stock market decline was relatively broad…as 10 out of the 11 S&P 500 sectors closed in negative territory. (Only the energy sector finished in the green.) That said, the breadth for the major averages (the advancers vs. the decliners) was not overwhelming at all. It was 2 to 1 negative for the S&P 500…and 3 to 2 negative for the NDX 100…and those are far from extremes given the size of yesterday’s declines. Therefore, since the SPX & NDX still stand very near their all-time record highs, we’re going to have to see quite a bit more weakness before this action creates much fear for investors.
However, with the action in the fixed income market over the past several months, it’s not out of the question that things could turn south rather quickly. We should remember that the initial declines in 2000, 2007, and 2020 were extremely quick…and extremely sharp. All three of those examples came after very strong rise in crude oil prices…and a similarly forceful rise in long-term yields. In each case, the stock market was able to ignore these moves for many months…but in all three cases, the eventual reaction in the stock market was a very rough one.
One issue when it comes to the fixed income market that few people are focused on right now is the high yield market. The HYG high yield ETF got hit hard yesterday…and this gave it the kind of decline that should be raising A LOT more warning flags than it is right now……History tells us that when a divergence develops between the stock market and the high yield market…which involves some significant underperformance from high yield…the stock market pretty much always experiences a substantial set back.
The divergence that has developed between these two markets has actually been going on for a long time. This is something we’ve written about several times in recent months, but after yesterday’s significant (further) drop in the HYG high yield ETF, we wanted to reiterated this situation again this morning……As you can see from the first chart below, as the S&P has made a series of new record highs since last October, the HYG has made a long string of “lower-highs.” So, there is a definite divergence developing…….We’d also note that has made two key “lower-lows” over that time frame. The first one took place in March…just as the stock market was rolling over…and the second one was this week. So, this week’s action could be something that will signal a period of material weakness in the stock market once again.
Looking at the second chart below, it compares the SPX with the HYG over the past few years. As you can see, the “directional correlation” is a very strong one. (In other words, the moves are sometimes bigger in one market or the other, but the “directional” moves are very strong.) However, you can also see that the HYG has declined in a very meaningful way recently…while the SPX has tested its June highs. So, unless the high yield market bounces back VERY quickly/strongly…it’s a good beet that the stock market will follow it lower before long…at least if history is any guide.
The one-day summit between President Trump and President Xi takes place today, so there could be some sort of an announcement that might keep stocks buoyed a little longer. However, it’s going to have to involved something more than just a 2-month extension on the tariff truce……Next week, we get a flurry of economic data, so that could have an impact as well………..However, if the action in the entire fixed income continues on the path it is right now, it’s going to create some real headwinds for equities…and those headwinds might be stronger than most investors are thinking right now.
