What Bond Yields Are Telling Us About Inflation

Stocks’ recovery these past few weeks has been dramatic.

Back on March 30, the major indexes were on the verge of correction territory. Investors were abandoning their positions to avoid further pain.

Yet by last Friday’s close, the S&P 500 (SPX) had punched out an 800-point (12.8%) gain. By any measure, that’s an extraordinary performance in just 13 days. The Nasdaq fared even better, putting on 16.8% over the same time.

The impact of the Iranian conflict was erased, and insatiable buying had pushed both indexes to a succession of all-time highs. Volatility dropped to its lowest level since early February.

You might be thinking that everything is back to normal. But the bond market is telling us something different…

Bond Prices and Yields

While stocks have regained all of their losses and then some, bond yields are still trading well above where they were when hostilities in the Middle East broke out.

From a low of 3.93%, 10-year U.S. government bond yields hit a high of around 4.48% on March 27. They’ve drifted to around 4.25% recently.

Typically, when war breaks out or uncertainty heightens, bond yields fall in anticipation of rate cuts as central banks try to support the economy. That causes bond prices to rise, since bond prices and yields move inversely.

If investors expect lower interest rates ahead, existing higher-yield bonds become more valuable, pushing bond prices up and yields down… and vice versa. So, for example, a bond paying a 4% coupon will be more valuable than a new bond yielding just 3%.

But the action in the 10-year bonds is different this time. The Middle East conflict has raised fears over inflation due to the jump in oil prices. That could force the Federal Reserve to raise rates.

Higher rates would make bond prices fall because an investor can buy new bonds offering higher yields.

That’s why I’m watching bond yields so closely. Inflation risk hasn’t gone away, which means neither has the prospect of higher rates…

Shaky Market Ahead

While yields have dropped a bit from their March high, they are still well above the 3.93% rate when the war broke out.

So while stock investors are enjoying the rally as though the Iranian conflict is now behind us, the bond market is telling us it still has concerns about inflation.

And if that concern persists, it could put the brakes on this sharp rally… and leave those who recently jumped onto the rally underwater.

While short-term momentum can push stock prices higher than their fundamentals justify, eventually the “higher for longer” interest rate narrative will reassert its control over the market. That’s when this rally will really be tested.

And if bond yields’ clue is right and inflation proves more persistent than expected, then stocks are setting up for another period of heightened volatility.

My advice? Stay vigilant and proceed with caution. But there’s also one particular ticker that could offer excellent trading opportunities as this dynamic plays out.

That’s especially true as a new Federal Reserve chair takes over in May, which will make the rate dilemma even trickier…

You can watch my briefing here for all the details.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict