Is the Bond Market Smarter than the Stock Market? My Take

Imagine you are part of a motley group of neighborhood friends. Some of you are cautious and patient, but many are impulsive. Your group is prone to mood swings triggered by greed and fear. Many in your group want to make a fast buck, and in this pursuit, they explore all kinds of strategies.

In an adjoining neighborhood, a different wealthier group of friends is more into preserving than growing wealth. This group is not as diverse, impulsive, and prone to mood swings as your group. And, it has a sixth sense for sniffing future economic ups and downs.

You look up to the other group because you benefit from its counsel.

Recently both groups experienced a unique situation characterized by extreme uncertainty. As always, to clear your confusion, you looked up to the other group for guidance. But you realized that the other group was equally confused. What do you make of this letdown by someone you regard for their wisdom? Read on for my take based on my recent experience.

Your group of friends is analogous to stock investors and the other group to bond investors. The unique situation is the extreme economic uncertainty that resulted from the pandemic.

Investors hate uncertainty. They like robust economic growth, full employment, and stable price levels. The government and the central bank strive for this utopian economy.

The central bank has the challenging task of balancing economic growth and inflation by tweaking interest rates. Interest is the cost of money; when money is cheap, we are likely to engage in more economic activity, and it is easier for businesses to make profits. Not surprisingly, investors are all the time anxious about what the central bank might or might not do with interest rates.

The central bank, however, does not have complete control over interest rates. Its actions directly affect short-term but not long-term interest rates.

Bond investors drive long-term interest rates. They consider the central bank’s impact on short-term rates and expectations of future economic growth and inflation for trading bonds. If the future looks rosy, investors sell bonds (bond yields rise), and if it looks bleak, they buy bonds (bond yields fall).

The bond market has earned a reputation for being a reliable barometer of future economic performance. Accordingly, equity investors keep a close eye on the bond market for insight regarding the economic outlook.

What exactly do equity investors follow about the bond market? The metric they track most is the yield on the U.S. Treasury 10-year note (10-year henceforth). Commercial banks use the 10-year yield as a benchmark for setting lending rates for mortgages, auto loans, and the like, and investment banks use the 10-year yield in discounted cash flow modeling for valuing businesses. Specifically, investors track the following for clues about the future:

The magnitude and directional movement of the 10-year yield
The difference between the 10-year yield and the yields of the 3-month bill and the 2-year note
The difference between the 10-year yield and the yield of risky 10-year corporate bonds

So, how did the market for U.S. government bonds stack up during the turbulent two years of the pandemic?

The bond market appears to have sensed the economic problems arising from COVID-19 before the stock market did. COVID-19 was first identified in Wuhan in December 2019; by the third week of January 2020, China had locked down Wuhan. Here are some data about how the 10-year yield and S&P500 performed in the first quarter of 2020:

On January 2, 2020, the 10-year yield was 1.882%, and the S&P500 closed at 3257.

On February 19, 2020, the 10-year yield had slid to 1.57%, while the S&P500 had marched to a high of 3386.

On March 23, 2020, the S&P500 bottomed at 2237; by then, the 10-year yield had sunk to 0.816%

After the pandemic began, the U.S. government and the Fed unleashed unprecedented fiscal and monetary stimulus. This stimulus was much more than a lifeline for the economy and rocket fuel for the stock market. The economic outlook started looking far less bleak, and bond yields began creeping up.

Amid the never-seen-before stimulus, chatter began about post-pandemic economic growth and inflation. Bond investors dread inflation, and the specter of inflation makes them dump bonds. When bonds sell off, bond yields rise and vice versa. Expectations of strong economic growth and inflationary pressures meant that bond yields would rise in anticipation of the Fed reining in monetary stimulus.

Seeing signs of inflation and a tightening monetary policy on the horizon, I made significant investments in bank and energy stocks during the last quarter of 2020.

The 10-year yield had been inching up after hitting a low of 0.54% earlier during the year.

• The 10-year yield breached the psychological 1.0% level on January 6, 2021, closing at 1.042%.
• About three months later, on March 31, 2021, the 10-year yield had risen to 1.747%; bank and energy stocks rode along merrily.

There was widespread talk that the 10-year yield would touch 2.0% by year-end. This talk was music to my ears.

But then something strange happened. The 10-year yield started falling. A fundamental rule is that bond yields rise when consumer prices are rising, and inflation is on the horizon. At first, I reasoned that the yield had gone up too high too fast, and after some consolidation, it would start rising again.

But the 10-year yield kept dropping; the energy and bank trades started to unwind, and money moved into high-growth stocks. I got unnerved and exited half my positions, squandering a large part of the paper gains I had at one time. At some point, it is hard for a small-time retail investor to ignore the collective wisdom of the market.

Within a few weeks, the yield scenario had turned upside down. The talk had changed from the yield rising to 2.0% to sinking to 1.0%; the yield bottomed at 1.181% on July 19, 2021.

The sustained bond market rally left everyone scratching their heads. Some said that the bond market had validated the Fed’s expectation of transitory inflation. That, both inflation and growth had peaked. That retail investors were influencing the bond market. That pension fund managers were immunizing their portfolios following hefty stock gains. That, foreign bond buyers were stepping in. That, the delta variant, was going to wreak havoc. And the mother of all explanations—technical reasons. These explanations probably had some merit, but they all smelled of force-fit rather than conviction.

Even the person with access to more information and research than anyone else did not quite know what to make of the bond rally. Yes, Fed Chair Jerome Powell acknowledged that there was no consensus at the Fed on what explained the significant decline of long-term yields.

Toward the end of July 2021, the Fed acknowledged that inflation was stickier and more aggressive than what it had expected and that it was time to retire the “transitory” qualifier for inflation. The 10-year yield started limping up again. On inflation, the bond market must force the Fed’s hand and not follow the Fed. In this instance, the bond vigilantes were in slumber.

I looked up to the bond market to untangle the confusing crosscurrents of inflation, economic growth, Fed policy, and the course of the pandemic and send a clear and compelling message. It did not live up to expectations. It seemed as unsure as anyone else; no wonder it exhibited stock-market type volatility with violent up-and-down swings.

The 10-year yield at year-end (2021) was 1.57%, well short of the 2.0% expectation. But the new year started with a bang. The 10-year yield shot up in the first week of 2022 at a clip not seen in decades.

So, is the bond market smarter than the stock market, as is often contended? It depends.

In familiar terrain, for which there is some sort of a playbook, heed the bond market. But, in unfamiliar terrain, the bond market can be as tentative as the stock market. In such a situation, read the bond market’s signal with caution. Do not be a lemming like me. Blindly following the bond market can make stock investors underestimate and underutilize their capabilities.