What The Bond Market Is Telling Us About Stocks

Inflation is affecting the bond market, which could spell trouble for the stock market (especially small caps). Here’s what we’re seeing.

We don’t talk much about bonds, because quite frankly they are not in our wheelhouse. But we always must keep one eye on the bond market. It is critical to our stock, options, futures, and commodities analysis.

Here’s why: The bond market (and more specifically, the yield curve) can give us clues as to why money is moving in or out of the market.

First, lets understand some of the mechanics of the bond market.

Bonds fall into the fixed income category, so they carry lower risk and lower returns than stocks. This also means losses are not devastating.

Bond investors and traders pay close attention to the yield curve, a flexible term structure that shows you the interest rates over time. Yields (or rates) move inverse to price, so if bond prices are moving higher that means yields are going down.

Bond maturity spans overnight to 30 years; this is called the duration. Investors and traders choose the duration based on how long they believe bonds will provide a good return.

While we don’t want to get too complicated with fixed income lingo, there are important markers to understand when evaluating the relationship between stocks and bonds. Yields often fall (and prices rise) when inflation is trending down or is lower. The inverse is true: higher inflation puts pressure on bond prices, and yields rise.

What does this have to do with stocks? If yields are dropping because bond prices are rising, small cap stocks benefit. They have a strong correlation to lower yields. The theory here is that lower yields mean lower borrowing costs for small cap companies, which can improve their valuation. (Higher yields are anathema to small cap stocks – and most stocks in general.)

Recently yields have started to rise, and the stock market understands the pressure in rates is going to be painful. If the Fed decides to hike rates on the short end of the yield curve because they feel inflation is too high, then most other maturities will likely follow in kind.

We have already seen rates on the long end of the curve rise for the two-year bonds, five-year bonds, 10-year bonds, and 30-year bonds. That spells trouble for the stock market as a whole until inflation starts to cool.