Here’s Why the Stock Market Is Tanking

The Dow Jones shed some 300 points between Wednesday afternoon and yesterday’s close.

The rout was on again today — down another 180 points.

What sudden noise has startled the horses — a new salvo in the trade war? The latest scandale politique? A fresh outburst of geopolitics?

No, no and no again.

Then what?

The answer arrives by way of the bond market — specifically the Treasury market.

Yields on the bellwether 10-year Treasury note have broken out since Wednesday… like an army that has broken the enemy’s center after a long stalemate.

From 3.05% Tuesday afternoon, yields have galloped ahead to a current 3.22% — their highest point since 2011 .

Not much difference between the two figures, you say. The big deal is what?

In nominal terms, little.

But this is a market that generally moves by the millimeter rather than the inch or the foot. The recent activity is a pandemonium.

But why now?

Bedazzling private-sector unemployment data and record service-sector numbers came out Wednesday.

The extravagant numbers feed the predominant narrative of an “overheating” economy.

Record-low unemployment also suggests inflation is finally coming to its legs — according to mainstream analysis anyway.

Rising inflationary expectations mean the market in turn expects the Fed to respond with further rate hikes.

But why should rising rates flabbergast the stock market?

If the Federal Reserve must raise interest rates to throttle an overheating economic engine, so much the better.

It keeps the engine humming at a nice, pleasant purr… and the economy at a safe speed.

The stock market should jump — not fall backward.

Ah, but as with much pertaining to the dismal science of economics, the business is… complicated. 

The field is a bedlam of half-truths, conditional truths, on-the-other-hands, maybes and maybe nots, sometimes yeses and sometime nos.

No iron linkage joins the stock market and the bond market.

They may rise or fall in unison, or individually — depending.

Rising 10-year rates are generally bullish for the economy, as stated.

But comes a point when the bull tail wind turns to bearish head wind.

For an economy fattened on cheap debt, rates above a certain point begin to tug.

Rising interest rates elevate the cost of debt. Loan repayments overburden corporate shoulders. Earnings suffer.

Rising rates also put drag on the overall economy.

Mortgages become dearer, new loans wither, auto sales slip, credit card rates sting that much harder.

Rising Treasury yields also take the legs from beneath the stock market.

They draw investors away from stocks into the safer waters of the bond market.

Explains Tim Ghriskey, managing director at Solaris Asset Management:

What it says, in general, is that higher interest rates make stocks look more expensive, especially relative to a fixed-income alternative. Once yields rise to a certain level, stock investors begin to get attracted to low-risk bond yields instead of higher-volatility stock investments.

But at issue is not so much the rising Treasury yields in themselves… but the pace.

The stock market seems at peace with a gradually rising yield. But a sudden jump its stomach cannot hold down.

As explains “The Heisenberg” of the eponymous Heisenberg Report:

The problem, as ever, is that there’s a fine line between “good” rate rise and “bad” rate rise, where the latter is indicative of an inflation shock, sharply tighter financial conditions and/or both. When it comes to delineating between “good” and “bad,” there’s obviously no set rule, but the pace matters. Rapidly rising yields over a short time frame [could lead to] a simultaneous sell-off in stocks and bonds.

February’s “correction” is instructive in this regard.

Ten-year Treasury yields had been on a steady march in the space prior.

The stock market shrugged its shoulders.

Then a gangbusters jobs report came out indicating surging wages. Markets glimpsed the specter of approaching inflation.

Treasury yields went skyshooting.

Too much, too fast, said the market. And the thumping 11% correction was underweigh.

So the question becomes:

Will the latest spike lead to another correction?

At this point the current yield spike almost perfectly matches the jump that led to February’s fireworks.

Deutsche Bank’s Aleksandar Kocic estimates the “red zone” — where surging 10-year yields threaten stocks — ranges between 3.20–3.70%.

In reminder, the 10-year rate is presently 3.22%.

In the danger zone, that is.

Slow down, says the stock market. Will the bond market listen?

To be determined…

Regards,

Brian Maher
Managing editor, The Daily Reckoning