Last week saw a major outflow out of equities. As a contrarian, I would be licking my lips and getting ready to buy the dip. The pessimism out there adds even more contrarian strength.
However, the reason why we are seeing an outflow out of equities must be analyzed. And when we do, we realize that there’s a chance for markets to see lower levels. All of it depends on this one chart.
Long time readers know what chart I will be talking about. As I have said, the first chart I look at in the morning is not the stock markets, but the largest market out there: the debt market or the bond market. It’s all about that 10 year yield right now folks!
Rising yields have put pressure on stocks for the last month. The debt market is now beginning to price in a hawkish Fed and major rate hikes. This really took a turn in the past few weeks. First we had Fed Brainard talk about the Fed selling off the balance sheet to the tune of $95 billion per month. More on this later. Secondly, Fed Williams really got markets and the 10 year yield moving by stating a 50 basis point rate hike for May is a “very reasonable option“.
The daily chart is what my readers and I have been following. Ever since that breakout back above 1..70%, we were bullish and looking for a retest and continuation higher. This happened. The question now is where to next? To answer this question, let’s go to the larger weekly timeframe.
I have a resistance zone between 3%-3.20%. But do I think yields will decline from here? If the Fed remains hawkish then no. I am actually expecting us to remain above 3%. This means that markets might drift a bit lower as the credit market prices in more rate hikes.
The thinking behind this is simple. Many believe this move in stock markets has only occurred because of low interest rates. Since nobody, especially pension funds, are making money holding bonds, that money had to flow into the stock market for yield. With rates rising, money could leave stocks and head to bonds because the yields are better. Nominally, a ten year yield bond will be paying you 2.8%. But in real terms, you need to factor in inflation. With inflation above 8%, and bonds yielding 2.8%, you are technically still losing out in real terms.
Inflation data will be important in upcoming months. It will decide on whether the market expects the Fed to raise interest rates more. Or, it will decide on whether the markets think the Fed is way behind the curve. Stocks do well in an inflationary period because of yield. Well, maybe cryptos are the only other markets where one can make more than 8% a month, or a large percentage number that can beat inflation.
A quick note on the Fed’s proposed tapering of $95 billion per month. Remember that most of the stuff that the Fed is buying are US treasuries. Bonds. If the Fed begins to sell these bonds, keep in mind the way bonds work. There is an inverse correlation between bond prices and yields. If the Fed sells off bonds bringing bond prices down, it means that yields will have to rise.
The stock market to watch is the growth, or technology focused Nasdaq. Growth stocks tend to not do well in a rising yield environment.
The Nasdaq remains below our support zone that we broke below at 14,200. This level is now resistance. We remain bearish on the Nasdaq unless we can climb and close above 14,200.
I also want to show you another chart that is freaking out the middle class in America:
The 30 year fixed mortgage has hit 5%. Interest rates are definitely rising. The scary thing is we could be heading to mortgage rates not seen since 2007 and before. We are looking at 7% and higher.
Putting it altogether, I want to show you all a scarier chart. If we look at the monthly chart of the ten year yield, it does point to the end of a 40 year bond bull market. Now, we expect bonds to sell off as yields and rates rise higher. By next year, we could be talking about a ten year yield between 4-5%. This impacts the middle class because of the amount of debt out there and the fact we are getting pinched by inflation. Not only are things getting more expensive, but debt is too. Think mortgages and even credit card bills. Borrowing cheap money to stay afloat might not be the smartest thing to do with yields rising.
The question now becomes how much longer can interest rates climb until something breaks. I can’t give you a number but I can just say that I think things will crack way before the Fed can get 6 or 7 rate hikes in.
The bond markets are the most important in the world right now. I do expect higher yields, and the stock markets to begin pricing this in. This means we could see a drift lower in equities for the time being. If the 10 year yield drops heavily, or begins to stabilize, that would be stock market positive. The worst case scenario would be a RAPID rise in the ten year yield. I mean rates moving higher and really fast. That would get markets tanking and we would be hearing the term “stock market crash”. Right now, equities are just beginning to price in and accept that higher rates are coming.