Bond Yields Threaten Breakout

4/5/2010


With March-quarter earnings season approaching and yields on 10-year Treasury bonds near a nine-month high, choppy near-term trading would not be surprising. Still, with the Dow Industrials and Dow Transports trending higher and quality stocks available at reasonable valuations, we are inclined to view any pullback as a correction in a bull market.

Shifting sentiment

Investor sentiment can shift markedly based on fleeting news developments, so extrapolating too much from near-term zigs and zags in the stock market is typically a mistake. But when stock prices move above previous significant highs, surpassing levels reached in a previous peak of bullish sentiment, it implies conditions are improving for equity investors.

In the bond market, new highs in yields imply that conditions are deteriorating, so bond investors will take note if yields on 10-year Treasury bonds break decisively above 4.0% — a level pierced only briefly since the 2008 financial crisis.

For stock investors, the implications of such a breakout depend on the cause. If 10-year Treasury bond yields jump because improving economic conditions push investors out of low-risk assets and allow the Federal Reserve to raise short-term interest rates, stock prices and bond yields could move higher together as corporate earnings improve.

However, stocks are likely to suffer if Treasury bond yields jump because of higher-than-anticipated inflation, the massive supply of debt needed to finance U.S. budget deficits, or concerns about the U.S. government’s ability to meet its obligations.

While it is impossible to know with certainty why bond yields are rising or falling, action in other markets can provide some insight. For our money, we’ll be watching the Industrials and Transports if bond yields break out to the upside. The economically sensitive Transports deserve particular attention.

Also worth watching is the yield spread between Treasury bonds and higher-risk corporate bonds. If the spread narrows amid a jump in Treasury bond yields, it would suggest bond investors are betting on a strengthening economy. If the spread widens, it could reflect worries that rising interest costs will strain the debt-heavy U.S. economy.

Conclusion

Rising bond yields represent a risk for equity investors, but we are not convinced a move in bond yields above 4.0% would trigger a bear market in stocks. For now, subscribers should hold 10% to 15% cash positions while emphasizing attractively valued shares of companies with solid growth prospects, including Aflac ($54; AFL) and Varian Medical Systems ($56; VAR).


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