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If Yields were a Stock, it would be on a "Watch Closely" Buy List

CAMS Weekly View from the Corner - Week ending 8/11/23


August 14, 2023


In our previous edition we opened up the topic of megatrends. These are trends that are long in duration lasting not months or years but decades and they hold their trend lines with near ease all the way through.

They become deeply entrenched in society to the point of becoming a foundation block in the economic landscape. This easily leads to them being taken for granted – it is just the way it is and seemingly always has been – even though it was not always this way.

What assists this assumed permanence is the trend lasts so long it becomes multi-generational. Bottom line, all adult age brackets are dialed in as this is the way it is, has been and seemingly will always be.

As the adage offers – no trend last forever. Every trend, even the megatrends, has a beginning and an end point. For megatrends the beginning and end points are rarely appreciated as such as they initially unfold. It usually takes years before it is accepted. Customarily, it takes that long before the masses realize this is the “new normal.”

Market participants continue to offer the 40 year mega downtrend of interest rates is over. Hold the thought.

Importantly, this does not mean we will never see a lower interest rate. Rather, the trend of ever lower rates is over is what they are offering. This is what it means when, in this case, the mega downtrend line for interest rates is taken out to the upside.

Every trend ebbs and flows, which is to say in this case rates will be higher and then lower etc. but through the process the downtrend line cannot re-establish itself. It’s the trend line that tells the story for the overall trend not the relatively short term blips on the screen of up or down action.

Yields

When bonds are issued they are issued at an expressed interest rate.

After issuance and once they begin to trade in the open market collective market participants then begin to “reset” (if you will) the interest rate by how they price the bonds. This then creates what the bonds yield to the new purchaser.

Bottom line, to keep this succinct and as simple as possible, you can think of the yield as what you will receive as an interest rate as a new purchaser in the open market for said bonds.

The important part here is collective market participants move the price of bonds up and down according to a plethora of analytical considerations. As an aside, this is why the bond market is often referred to as the “smartest market” in light of the massive amount of analytics that go into the collective pricing of bonds.

The Cost of Capital

Interest rates are viewed as the cost of capital. The bond market plays a tremendous role is setting this cost by how they price bonds.

Cost of capital is a bedrock foundation piece to the economic system. The tributaries that a cost of capital topic open are many in particular to how they feedback loop to other tributaries. There are many details here - too many for this edition but cost of capital is a crucial input within the economic structure.

You are a corporation and you want to raise money for X capital investment initiative via a bond issuance – that’s your cost of capital. You are a head of household and want to purchase a home – that’s your cost of capital. You are an entrepreneur and want to secure a Commercial & Industrial Loan – that’s your cost of capital. Cost of capital – as stated, is a bedrock foundation piece in the economic landscape.

As offered the bond market and its collective participants play a tremendous role in pricing bonds which in-turn establish the interest rate (think yields) which in-turn play a notable role in establishing the cost of capital for the financial system.

This all goes beyond “what will the Federal Reserve do” or you name it D.C. entity as the bond market plays a significant role too and its importance is often not recognized.

To underline this it elicits a memorable quip from a notable politician from the 90’s as he offered in his next life he wanted to be a bond market player. This in light of the tremendous role said market played relative to D.C. policies and how the bond market had a tremendous say in setting the cost of capital for the economy at large right down to constituents.

Current Bond Market Setup


The above chart depicts the Ten Year Treasury bond dating back four years. To lessen the noise of daily trading we made this a weekly chart in order to see more clearly what collective bond market participants are doing with the Ten Year Treasury on a Yield (think interest rate) basis.

As offered, bond market participants trade these bonds daily and in so doing move the price up and down. If they push prices down then the yields (again, think interest rate) move upward. Simply, prices down then interest rates up.

Our thin black line denotes the upward trend in yields (as prices have fallen) since mid-2020. Since late fall of 2022 yields have moved sideways.

Our red line highlights how bond market participants have refused to let yields fall on a trend basis.

They have now worked their way higher to the point of being at the highest levels we have seen dating back to the highs of 2022. If these yields were a stock it would be on a “watch closely” buy list in light of it looking like it wants to resume its established uptrend.

Bringing it All Together

The significance of the Ten Year Treasury yield is this vehicle is viewed as a benchmark interest rate.

As bond market participants have pushed yields higher by selling off bonds the cost of capital moves higher. As shared, the cost of capital is an essential backdrop for the economic system. Higher cost of capital equals tighter financial conditions.

The above chart is a metric that may be offering general financial conditions will be tightening. As it stands, per the chart above, bond market participants are as close as they can be to pushing yields past the highest levels we had seen in all of 2022. If they do so the stock market may very well take note.

To this observation we cannot help but ask have they already begun to take note? Tech stocks as a group have dropped by 10% in the previous three weeks.

Tech stocks trade like long duration bonds. Duration is a measure of an instrument’s sensitivity to rising interest rates. Per our chart the bond market is raising yields (interest rates) by selling off bonds and reducing their price.

It appears stock market participants are taking note of bond market participant messaging. If these yields breakout higher from here we have to believe, based on recent tech stock price action, that the stock market as a whole will take note.

In addition, if these yields break higher from here it will be yet another message from the bond market that the 40 year mega downtrend in interest rates has passed us by. Watch the bond market close – its near-term price/yield action will be important.

I wish you well…


Ken Reinhart


Director, Market Research & Portfolio Analysis

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