- The bond market is flashing a warning…
- “The mills of the gods grind slowly, but they grind exceedingly fine”…
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Dear reader,
The fleeting fancies of the market, its momentary moods, its passing passions, hold little fascination for me.
They amuse me — at times to the verge of tears. Yet they do not fascinate me.
It is the grand sweep that holds my fascination… the long view… the view of the circling eagle high overhead.
And the eagle’s gimlet gaze presently fixes upon the bond market.
As I have noted previously, clinging to our aviary theme:
The flighty birds of the moment congregate in the stock market.
Yet the owls — the wise owls — nest in the bond market.
The Bond Market Is Smarter Than the Stock Market
The bond market will tell you where the economy is heading, say the wizened and grizzled veterans.
The bond market is not so easily foxed by the Federal Reserve’s garish and gaudy tricks.
With knowing eyes it penetrates the magician’s secrets… and exposes the fraud upon the stage.
The bond market knows where the rabbit came from. It knows where the vanished gal is hiding.
It observes the wires holding the levitating subject aloft.
New York Times economics reporter Neil Irwin:
- Savvy economic analysts have always known the bond market is the place to look for a real sense of where the economy is going, or at least where the smart money thinks it is going.
The Bond Market Is Restoring Reality to a Stock Market Divorced From Reality
What does the smart money presently envision for the economy and the stock market?
Market observer, Quoth the Raven:
- Bond yields are… forcing reality back into a market that had become increasingly detached from it…
- By Friday morning… the U.S. 10-year Treasury yield had climbed nearly 9 basis points to 4.544%, marking its highest level in almost a year…
- Government bonds, precious metals, and international equities all sold off simultaneously as investors began repricing inflation risks, geopolitical instability, and the growing realization that central banks may not be rushing to save markets anytime soon.
As I write — incidentally — the 10-year Treasury yields 4.627%… or an additional 8.3 basis points.
Signs of Stress
And why does the foregoing matter, sir?
- That matters because this is how stress sometimes tends to emerge in overextended markets. It rarely starts with equities themselves. It often begins in credit markets, rates markets, or funding markets before eventually spilling over into stocks.
- Bond markets… tend to be less interested in speculative narratives and far more focused on inflation, fiscal deficits, growth expectations, and the actual cost of money.
- When yields move this aggressively higher in such a short period of time, financial conditions tighten almost immediately…
- Most importantly, the higher yields go, the less rational it becomes to pay extreme multiples for speculative growth stocks that have been pricing in a near-perfect future.
Too Few Stocks Doing Too Much Lifting
Many and oft, in these pages, I have argued that the stock market is “priced for perfection.”
The stock market projects deep azure skies to the farthest horizon. Yet as I have also argued, perfection is a condition rarely attained upon Earth.
Please continue, sir:
- This no longer resembled a traditional bull market built on broad participation, earnings growth, or healthy economic expansion. Instead, I described a market increasingly driven by narrow leadership, speculative options activity, and momentum chasing concentrated in a handful of names…
- That combination matters because it tells you this rally has been heavily dependent on a shrinking number of stocks doing most of the work while market structure becomes increasingly fragile underneath.
- And that fragility becomes far more dangerous when interest rates begin moving against speculative positioning.
In reminder, interest rates are presently moving against speculative positioning.
Yet let us return to the eagle’s view.
The End of the 40-Year Cycle
The bond market, like many Earthly concerns, runs to cycles. These cycles tend to endure some 20 years in length, taking one with the other.
Some cycles are less lengthy. Some are more lengthy. Yet 20 years is roughly par.
Interest rates summited at 15% in 1981, to conclude the rising cycle.
Interest rates proceeded to embark upon a 40-year cycle that guttered at 1% in 2021.
Only then did rates assume their reversal.
Thus the 40-year cycle of interest rate decline doubled the average 20-year cycle duration.
It was an extended period of stock market outperformance.
Yet I operate from a theory. It is a theory I in fact cherish.
Mean Reversion
The theory I cherish is the theory that time irons out extremes.
Scales balance even, that which goes up comes down, that which goes down comes up.
And the greater an elastic band is stretched, the more energetically it will snap back.
Plenty of potential energy can accrue across a 40-year cycle that lasts 20 years on average.
Thus the interest rate cycle, which transitioned a mere five years ago, has loads of potential energy awaiting conversion to kinetic energy.
And if the term “mean reversion” has anything in it — I believe it does — the market is in for a whale of a mean reversion across this cycle.
Markets Became Used to Declining Rates
Yet the stock market has remained, largely, priced for perfection. Why?
Mr. James Grant is editor of the eponymous Grant’s Interest Rate Observer. From whom:
- Persistent, if not continuous declines in rates have been the norm for the careers and investment minds of most living human beings.
- Consequently, expectations are deeply embedded in our collective psyche that rates do one thing, which is to decline. Yet here we are, observing them go up… So far, the stock market pretends not to notice.
I am not the least bit surprised the stock market has pretended not to notice.
Recall, the stock market is where the flighty birds congregate. And that the wise oils nest in the bond market.
I hazard the latter will be munching popcorn at one point — and at the former’s expense. When?
I cannot precisely say. I cannot even imprecisely say.
The Mills of the Gods
Mr.Grant continues:
- I think people are still trying to deal with the shock of the perception of the possibility of much higher rates for a long time. Not every company has had to refinance so far, not every private equity company has met a hostile reception in the credit markets and not every country has had to face the consequences of a potentially ruinously high national invoice for interest expense.
- All this is still in the making.
Just so. Yet things that are in the making come eventually out of the making. They are made.
“The mills of the gods grind slowly,” as said ancient Greek Sextus Empiricus…
“But they grind exceedingly fine.”
How fine they will grind in this particular instance… again I do not know.
I hope merely that the gods are kind.
Regards,
Brian Maher
for Freedom Financial News
