The bond market is one of the most underrated spaces on Wall Street.Stocks are the most well-known investment out there, while crypto has been the most exciting over the past few years (for good and bad reasons).
Yet bonds tower over both markets in size — and arguably, in importance. And right now, bonds are trying to tell us something as Treasury yields soar to 16-year highs.
But what exactly bonds are saying is a bit of mystery.
The most important number in markets
If you’ve been following financial news closely, you’ve probably noticed another wave of worries pop up in headlines — China, inflation, tech, government debt, the Federal Reserve’s plans at Jackson Hole.
And they all have one common thread: interest rates.
Before I get too nerdy, here’s a quick rundown on bond markets. Bonds are essentially loans made from investors to companies and governments. Many investors hold bonds to maturity and collect interest from the borrower, but it’s also possible to trade bonds. Each bond has a price (what you’d get if you sold before maturity) and a yield (the rate you’d get paid from the borrower). Prices and yields move in opposite directions.
The yield on 10-year Treasuries is one of the most important numbers for investors to watch. It’s seen as a proxy for how people feel about the economy, and it sets a standard for how much return you should expect on stocks and other investments. After all, if you’re making less return than what you can get in near-riskless government debt, what are you even doing?
Now, let’s talk about why yields are causing so much drama.
The highly watched 10-year yield just reached a 16-year high of 4.3%. And while rising rates aren’t exactly a new thing, the latest step higher seems to have set off a chain reaction in markets.
Stock prices have tumbled, crypto prices have tumbled more, inflation fears have roared back, mortgage rates are at 20-year highs, and people are generally becoming more concerned about another financial crisis in the making.
All because bonds (seem to) rule everything around us. At least, more than they usually do.
A strong economy is a good thing
So why are yields climbing so quickly? Wall Street has some conflicting theories.
Some analysts are blaming higher yields on unusual catalysts, like the Bank of Japan’s decision to loosen up on its own bond market control. Others see the spike in yields as a sign that inflation is flaring up.
But what I’m hearing from bond markets — and what they usually tell us through higher yields — sounds like an inherently good story about the future.
Yields tend to increase this fast when the economy is getting stronger, and we know from recent data that this may be the case.
History backs this up. Over the last 60 years, the 10-year yield’s biggest rallies happened at the beginning of economic cycles — and consequently, in the early stages of long stock market rallies. And here’s the kicker: Higher yields were more often a sign to lean into stocks, not run away from them.
This is why Wall Street’s uproar around yields feels a little dramatic. I understand it — things are clearly changing, and it can be hard to stay calm when the ground is shifting underneath you. But remember that a strong economy is a good thing, even if it causes some angst at first.
Of course, higher growth could lead to higher inflation if people spend enough money. But even then, is inflation a real threat, or is it just an excuse to sell? There may not be enough evidence to worry about an inflation spiral just yet, as I explained in a recent post. And in a way, higher yields can actually help control inflation if they discourage people from borrowing money.
So what does this mean for me?
Don’t panic. Even though yields have caused stocks and crypto to stumble, they may not be enough to derail this bull market. As far as we can tell, inflation is still near 3% and the economy is still growing.
Look for value. A wise colleague once told me that there are two ways to make money in the stock market: looking for what’s growing, and looking for what’s under-valued. High-growth investments have worked well this year, but soaring yields may force investors to search for value — sectors and stocks that are trading at low prices relative to their earnings.
If you look at today’s price-earnings ratios, you’ll see that eight of 11 S&P 500 sectors are still trading at a discount to the S&P 500’s own value (based on expected earnings over the next 12 months). There are still pockets of opportunity out there, even if they don’t look like your typical momentum stocks.
Think about your next investment. Remember — bond yields and prices move in opposite directions. So if you don’t expect yields to stay high, you probably also think bond prices will rise. Bond ETFs (and options on these funds) give you a way to invest in the future for bond prices without actually buying or selling a bond. In fact, the iShares 20+ Year US Treasury Bond ETF (TLT), the highest-traded government bond ETF on the US market, is having a record month for both share and options volumes.
Pick up a sanity hedge. If you’re still not feeling good about the economy, there may also be a way for you to capitalize on high yields. Treasuries have historically acted as a decent portfolio cushion during recessions. So if you think people are too optimistic about the future, it may be time for you to pick up a cheap sanity hedge.
*Data sourced through Bloomberg. Can be made available upon request.