What Bonds are Saying

Most investors assume that stocks and bonds move in opposite directions. This is probably because the two have behaved this way for the past 8 years. In truth, stocks and bonds maintain two distinct relationships. When the Fed is active, stocks and bonds compete for liquidity and thus move in opposite directions (yields move in parallel). When the Fed is more dormant, stocks and bonds actually move together.

The 11-year chart below shows these two relationships. The first set of vertical lines on the left mark the last period (1996-1999) that stocks and bonds moved together. As you can see, yields and the SPX formed a giant X from mid-1996 to late 1998. Then, when Greenspan got busy, yields and the SPX began moving in rough parallel, the relationship we still see today.








Below is a zoom-in of the right-hand set of parallel lines from the chart above. The first arrow marks the beginning of the famous "disagreement" between the bond market and the Fed that currently rages on. Once Bernanke paused in late June, bond bulls stormed in and bought the 10-year year ahead of any concrete data that said it was time to do so. The smartest guys in the room stopped following the ball.

Meanwhile, the economy didn't fall off a cliff, 2006 Q3 earnings were good and the SPX kept rising...and rising...and rising. This created the giant X between stocks and yields that you see in the chart below. Finally, in Decemeber, the bond market blinked. Just like this past Friday, bond investors got religion because of a positive employment report (the second arrow). Since then, stocks and yields have resumed their crude, parallel journey.








The chart below shows the 4-year rising trendline that some call, "the recession line". The rule of thumb among many pros is that as long as yields don't tumble below this line, we won't see a recession. Obviously, it appears to have recently survived its most serious test to date.








I'm a big believer in listening to the pundits but trusting the market. This is TOF's famous, "follow the ball." Based on the past 9-months or so, the market has keyed more on jobs than on any other slice of data. Regardless of what the pundits say, the bond market says that as long as America stays gainfully employed, the US is unlikely to tip into recession.

I also think this applies to the Fed as well. Stumbling employment is the likely moment when you'll see Bernanke finally step in and lower rates. Until then, the Fed will likely hang tough.

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